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THE FAILURE OF HIH INSURANCE

Volume Ill

Reasons, circumstances and responsibilities

Apri12003

© Commonwealth of Australia 2003

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National Library of Australia Cataloguing-in-Publication data:

Australia. HIH Royal Commission. The failure of HIH Insurance.

ISBN 0 9750678 2 6 (volume III)

ISBN 0 9750678 5 0 (set)

J. HIH Insurance. 2. Insurance companies-Australia.

3. Insurance-Australia. 4. Business failures-Australia.

I. Title.

368.006594

Printed by National Capital Printing, Canberra

Canberra Publishing and Printing, Canberra

Contents

18 The inadequacy of management information 1

18.1 Financial systems 1

18 .2 Reconciliation of ledger and bank accounts 3

18.3 Budgets 4

19 Regulatory solvency 9

19.1 The Cotesworth letters of credit 9

19.2 Netting-off 23

19.3 The September 1999 quarterly returns 30

19.4 Possible contraventions and referrals 34

20 The effect of incorrect accounting 43

20.1 An accounting exercise 43

20.2 FAI- 1998 47

20 .3 HIH's consolidated balance sheet reconstruction as at 30 June 1999 48

20.4 Adjustments to the consolidated balance sheet ofHIH and subsidiaries at 30 June 2000 56

20 .5 Insolvent trading 61

21 The audit fu nction 65

21.1 Approach to this chapter 65

21.2 Procedural fairness 66

21.3 Audit approach 68

21.4 Relationship between Andersen and HIH 85

21.5 Audit work 97

21.6 Final comments 166

22 Home Security International: a case study 191

22 .1 HSI prior to the takeover 192

22.2 HSI from acquisition until April 2000 194

22 .3 The Ness acquisition-April2000 to September 2000 202 22.4 HIH sells out of HSI-September 2000 to December 2000 210 22.5 Cooper's claims-December 2000 to March 2001 214

22.6 Conclusion 236

22.7 Possible contraventions and referrals 240

23 Other aspects of the governance of HIH 259

23.1 Corporate governance benchmarks 259

23.2 The HIH board 260

23.3 Decisions on major transactions 273

23.4 Audit committee 278

23.5 Human resources committee 282

23.6 Related party transactions 286

23.7 Misuse of corporate resources 301

23.8 Information to the board 315

23 .9 Preference share issue 319

23.10 Pacific Eagle Equities 328

23.11 Possible contraventions and referrals 339

24 The regulators 360

24 .1 APRA 361

24.2 State regulators 442

24 .3 Regulatory responses of ASIC and the Australian Stock Exchange 462

iv Th e failure of HIH: a critical assessment

VOLUME I

Explanatory notes

The failure ofHIH: a critical assessment

Policy recommendations: a summary

Understanding this report

2 How the inquiry was conducted

3 A brief corporate history

4 The industry and regulatory context

5 Provisioning and reinsurance: general principles

6 Corporate governance

7 Financial reporting and assurance

8 Regulation of general insurance

9 State and territory regulation

10 Taxation and general insurance

11 A policyholder support scheme

Appendix A

Appendix B

Appendix C

Appendix D

Appendix E

Appendix F

Appendix G

Appendix H

Glossary

Abbreviations

Terms of reference

Parties

Witnesses

Policy submitters

Operational statistics

The Commission team

Offence provisions: an outline

Correspondence from the public

VOLUME II

12 The Winterthur years

13 Unprofitable international operations

14 The impact of the F AI acquisition

15 Under-provisioning for claims

16 Use of whole-of-account reinsurance

1 7 The demise of HIH

vi Th e failure ofHIH: a critical assessment

18 The inadequacy of management information

Amidst other problems, HIH was plagued by a variety of deficiencies in its information systems. As a result, it was deprived of timely and reliable information as a basis for management decisions. Questions concerning the reliability of information provided to management and the group's ability to keep track of the financial impact of its operations arose time and again throughout the Commission's

inquiries. The problems identified were exacerbated by a complex corporate structure and the group ' s ever-expanding operations. This chapter discusses three areas of deficiency in management information that illustrate the kinds of problems identified:

• HIH's electronic financial systems

• reconciliation of ledger and bank accounts

• budgets.

18.1 Financial systems

Accurate information systems are a vital part of a viable insurance business. Without reliable data on liabi lity for claims, an insurer faces the real danger of underpricing its products and so trading unprofitably over an extended period. Warren Buffet, the chairman of Berkshire Hathaway, has described that risk in the

following terms:

Not knowing your costs will cause problems in any business. In long­ tail ... where years of unawareness wi ll promote and prolong severe underpricing, ignorance of true costs is dynamite.1

Similarly, information systems must be capable of producing material that will enable the board to assess the financial position and performance of the company properly and to detect any deterioration in performance on a regular basis. Information systems must be continually maintained and monitored. Executive management cannot take a passive approach to the receipt of management information. It is the responsibi lity of executive management to monitor the integrity of fi nancial systems and the financial reports those systems produce. The responsibilities of directors in respect of the task of obtaining reliable information have recently been discussed by Austin J in ASIC v Rich. 2

The importance of maintaining information and accounting systems capable of producing and retaining accurate financial information is recognised in the

The f ailure of HIH Insurance

Corporations Act 2000. 3 Under the legislation in force prior to its demise, HIH was obliged to maintain financial records that correctly recorded and explained its financial position and performance and enabled true and fair financial statements to be prepared and audited.4

HIH operated several insurance and accounting systems to manage its insurance business. 5 The Oracle system was purchased after the ere takeover and was the general ledger system used by HIH. 6 It recorded financial data for both the Australian and overseas operations. The Aegis system was acquired by HIH during the takeover ofF AI. It held policy details and claims histories for F AI business. The liability and indemnity recording system contained the data for a number of HIH portfolios, including professional indemnity, public liability, trade credit and builders warranty. 7 Finally, the GEN+ system was developed by HIH to bring together the existing systems in order to provide greater functionality and to meet year 2000 compliance requirements.

18.1.1 Problems with GEN+

In September 1997 GEN+ was introduced to the Queensland operations. Its introduction resulted in a number of problems. These included an inability to produce commission statements (required to ensure accurate commission payments to agents and intermediaries), an inability to produce debtors' statements, an inability to process correct premiums for financial endorsements and the production of insufficient management reports for the business. 8 Those problems had not been rectified by the middle of 1998. 9 In August 1998 approximately 85-100 people were employed to perform manual procedures around GEN+ until the problems were rectified. 10

GEN+ was implemented in New South Wales and Victoria in June 1999. A later review revealed that the problems experienced by the Queensland operations were also being experienced in New South Wales and Victoria. There was a significant back-log of data and concerns over the integrity of GEN+ data and the accuracy of management reports. In addition, management was not receiving the necessary key performance indicators and there was no automatic daily interface between GEN+

and the general ledger. 11

Throughout 1999 a number of management reports prepared for board meetings of HIH subsidiaries recorded that business lines were unable to report any financial information or credible financial information due to problems with GEN+.12

These problems continued into 2000. An internal audit report in February that year noted that there was a significant number of unreconciled bank accounts across the group that related to the implementation of GEN+. 13 In May 2000 further data problems with GEN+ were identified in an internal audit report regarding credit

control. The report rated the credit control of HIH as 'unacceptable' and noted that significant delays in processing data on GEN+ had resulted in a large and

2 Th e inadequacy of management information

unacceptable build-up of historical transactions. 14 Senior HIH personnel were continuing to express serious concerns about the accuracy of the data in GEN+ in November 2000. 15

On 1 January 2001 GEN+ was transferred to the joint venture between Allianz and HIH. Allianz continued to experience difficulties reconciling and processing the data generated by the system. 16

Although Fodera acknowledged that GEN+ had caused considerable problems, he said manual procedures established to resolve those problems had produced accurate and complete financial information. 17 He denied that GEN+ had an impact on the underwriting decisions, pricing policy or accuracy of data given to actuaries by HIH. 18 Pye also acknowledged the continuing problems caused by GEN+ although he could not recall the specific problems identified in the internal audit reports, including the inability to produce debtors' statements. 19 It was Pye' s understanding

that by June 2000 many of the problems with GEN+ had been resolved. 20

Although efforts were made to resolve the problems and manual procedures were used to produce accurate financial information, HIH's ability to operate effective credit control and debtor management processes was impaired as a result of the problems with GEN+. Further, the manual processing was expensive and provided the temptation to capitalise costs that should have been expensed. The topic of

deferred IT costs is dealt with in Chapter 21 .

18.2 Reconciliation of le dger and bank a ccou nt s

The reconcil iation of data is an important internal control in ensuring the accuracy and completeness of a company's general ledger. Without regular and comprehensive reconciliations the integrity of information recorded in the general ledger is compromised.

There were problems in HIH 's reconciliations that extended over a long period. In September 1996 HIH embarked on Project Max following problems identified with data acquired through the takeover of CIC. The aim was to improve the accounting and reporting controls within HIH and to 're-establish the integrity of the

accounting functions of the group' ? 1

The results of Project Max were reported to the HIH board by Andersen in December 1996. They noted that whilst most balance sheet reconciliations had been brought up to date there remained ongoing instability of the insurance and accounting systems. 22

In September 1999 Andersen recommended that HIH introduce procedures to monitor and review all reconciliations as part of its monthly procedures for closing the books. 23 The internal audit division of HIH reported in February 2000 that the bank reconciliation process within HIH was 'unacceptable'. This was because of the age and amounts of outstanding reconciliations and because of weaknesses in the

Th e failure of HIH Insurance 3

reconciliation controls.24 HIH then began a reconciliation of all balance sheet ledger accounts. This process was undertaken following pressure from Andersen who had not been able to perform a complete reconciliation of all ledger accounts since Project Max in December 1996.

Andersen ' s management letter for the 30 June 2000 audit noted that HIH' s reconciliation processes had improved. 25 However, Andersen's working papers identified that, as at September 2000, not all balance sheet reconciliations had been completed. Pye could not recall whether HIH had satisfactorily resolved the reconciliation problems prior to signing off on the June 2000 audit. 26 Importantly, following the completion of the audit by Andersen, the process of reconciliation of the ledger accounts lost momentum. A number of reconciliations remained outstanding, some containing transactions dating back to the acquisition of CIC in

1995 .27

Senior personnel in the financial services division acknowledged that there were significant and ongoing problems with data reconciliation resulting from system problems, primarily GEN+.28 Although considerable efforts were expended, particularly in the early to middle part of 2000, there remained a number of unreconciled accounts at the date of appointment of provisional liquidators.

Fodera asserted that, whilst he was not aware of the detail or extent of the problems with bank and ledger reconciliations identified in internal HIH documents, he believed that HIH had at all times completed material reconciliations29 and that any unreconciled bank and ledger accounts after completion of the financial statements would have been immaterial. 30

It is extraordinary that HIH was not able to carry out a comprehensive reconciliation of all its balance sheet ledger accounts between late 1996 and March 2000. Given the effect that unreconciled accounts may have had on HIH' s internal and external financial reporting, it was not enough simply to complete material reconciliations.

18.3 Budgets

A budget is the financial quantification of the expectations or plans for the future actions of an entity, ordinarily including its financial performance, cash flows and financial position. It is an important tool in managing expenditure and assessing performance.

The measurement of actual profits against budgeted profits is a key management tool for assessing the ongoing financial performance of an organisation. A continuing failure to meet budgetary targets may indicate fundamental problems in the business strategy or underlying performance of the business. It may also call into question the carrying value of the assets of the organisation, especially intangible assets.

4 The inadequacy of management information

18.3.1 Process of setting budgets within HIH

HIH produced an annual budget for the consolidated group for all financial years between 1996 and 2001. 31 The budgetary process was coordinated by the financial services division, which sent out budgetary guidelines to all divisions several months before the beginning of the new financial year. 32 The guidelines included, among other things, the budget timetable, an outline of the responsibilities of divisional and executive management and templates to record the budgeted figures. The guidelines required that all divisional managers produce a business plan to support the budgeted figures. 33

In the later years, the guidelines set out a number of key earnings ratios and financial targets for the group to achieve. The net profit after tax and gross written premium targets increased significantly between the 1999 and 2000 financial years. 34 The guidelines for the financial year ending 30 June 2000 stated that the targets were required to be achieved in order to ' meet both senior executive and

shareholder expectations' ?5

The board received quarterly financial statements. From 1995 onwards, the quarterly financial statements included details of the year-to-date financial results and compared them to the budgeted results. The exception was the final quarter, when forecast figures appear to have been used. 36 A budget presentation was made

to the board shortly before the start of the new financial year. The presentation included a brief commentary on market conditions across all Australian and overseas divisions. It also identified the actual figures for the last completed financial year, the forecast annual figures for the current financial year and the

budgeted figures for the following financial year? 7

Table 18.1, produced from financial reports and budget presentations to the board, compares the actual to budgeted figures for HIH for the financial years 1996 to 2001. 38

The table shows that HIH fai led to meet its budgeted figure for core earnings by a significant percentage in each financial period. Although HIH substantially met its budgeted figure for net profit before tax for the 1996 financial year, it failed to meet this category in subsequent financial years.

The consistent failure to meet budget represented a serious breakdown in the internal financial controls of HIH. The consistent pattern suggests that senior management were setting aggressive or overly optimistic budgetary targets for HIH's operating divisions. Further, they were failing to reflect on the previous failures to make budget or to adopt a more conservative and realistic approach to the setting of budgets. In this respect, the use of budgetary control as a strategic planning tool was rendered ineffective.

Th e failure of HIH Insurance 5

Table 18.1 Comparison of actual to budgeted figures for HIH, 1996 to 2001 financial years

December

1996 1996 1997 1997 # 1998

Actual Budget Actual Budget Actual

Financial year/ period ending $M a $M• $Mb $M b $Me

Gross written premium 1407.3 1367 1725.1 1789 2079 .8

Gross earned premium 1345.8 1310 1708.5 1690 2030.9

Net earned premium 931.5 940 1233.5 1287 1410.7

Core underwriting (loss )/profit -18.1 -3 -33.8 -12 -73 .4

Operating profit/(loss) before income tax 91.1 93 90.5 109 61 .8

Operating profit/(loss) after income tax 61.1 61 61.8 72 37 .6

Notes # 1997 Budget represents original budget plus HIH America and Colonial Mutual General full year forecasts * 2001 budget revised to account for the financial impact of the Allianz transaction a. BRD.022.046 at .049

b. BRD.029.128 at .129

c. BRD.048.114 at .115 d. BRD.054.053 at .054 e. BRD.059.071 at .072 f. SBB.057 .688_001 at 688_0044

g. AND.6006.0147 at .0155 h. SBA.171.710_001 at 710_002

Six months to June

1998 1999 1999

Budget Actual Forecast $Me $M d $M d

1868.7 1455.1 1486.3

1824.6 1408.3 1418.6

1410.7 913 .9 1009.3

-24.1 -100.3 -80

125.9 40.1 67.8

84.4 -58.8 45.4

Six months

June to December

--2001 2000 2000 Revised 2000 Actual Budget Budget* Actual $M • $Mt $M g $M h 2867.6 2824 .9 2740 .6 1368.4 2862.6 2579.6 2693.5 1503.8 1995.4 1965.5 2061.7 1069.8 -103.5 -104.2 -488 .6 37 .2 126.4 85.7 -695.5 18.4 85.4 85.7 -695.5

Notwithstanding the setting of aggressive budgetary targets for the operating divisions, the executive office did not consider itself bound by its own budget. For example, for the 2000 calendar year, the executive office exceeded its budget by $23 .155 million, approximately 250 per cent. 39 Williams said he had always regarded budgets as ' a guide'. Such an attitude by the chief executive officer is alarming.

The failure of the board to identify and act on the failure to achieve budget represented a serious failing within HIH. It was particularly significant given the extent to which board members asserted that they had relied on budgets to exercise financial control over the actions of the executive management ofHIH.40

Finally, HIH personnel relied on budgeted figures to value goodwill for the financial years ending 30 June 1999 and 30 June 2000. 41 Given the history of consistently inaccurate budget forecasts, this was an inappropriate basis upon which to value a material intangible asset.

2

4

9

10

11

12

13

14

15

16

17

18

TEND.0022.001 at 008.

[2003] NSWSC 85. Section 286. Corporations Law s. 286. T289/6 to T289/27 (Wilkinson).

Tl5892/22 to Tl5892/27 (Martin). WITS .0127.00l at 041 par. 181 (Eade); WITS.0113 .001 at 004 par. 12, 023 par. 116 and 029 par. 142 (Bacsak).

SBB.OI5.847 001 at 847 003 . - -WATS.0019.244. SBA.l90.793 001 at 793 002 . - -WATS.0019.245. SBA.194.189_001; SBA.192 .128_001 ; SBA.194.076_001 ; SBA.194.205_001 ; SBA.194.216 001.

WATS.0019.001 at 016. WATS .0019.035 . SBB.032.566 001 at 003 . WITS.0228.001 at 006 par. 6.3 (Waters).

T 18463/5 to Tl8463/11. Tl8479/ IO to Tl8479/52 . 19 Tl6947/20 to Tl6947/40. 20

Tl6948/36 to Tl6948/53. 21 BKEM.0046.001 .

The failure ofHIH Insurance 7

22

BRD.020.006. 23 AUDC.015 .099. 24

WATS.0019.001. 25 AARA.0571.004 at 011. 26

T16951/9 to Tl6951112. 27 WITS .0276.001 at 003 par. 9 (Chapman). 28

Tl6474/5 to T16474/ 13 (Howard); T15871 /26 to Tl5871/34 (Cubbin). 29 T18473/21 to Tl8474/4. 30

T18473/46 to T18474/4. 31 BRD.022.046 at .049 ; BRD.020.216; BRD.027.000; BRD.041.848; SBB.057.688_001 ; AND.l671.0008.0173 . 32

AND.l384.0004.0396. 33 SBB.017.777 001. 34

SB0.005.529 _001 at 529 _005 , SBB.Ol7.777 _001 at 777 _004. 35 SBB.Ol7.777 001 at 777 004. - -36

BRD.054.053; BRD.055 .089; BRD.056.135 (examples of quarterly accounts presented to board). 37 SBB.057.688 001. 38

HIH budget for 200 I FY but half year results to 31 December 2000. 39 SBA.l65.253 020. 40

Tl5440/26 to Tl5440/37 (Gorrie), T13939/44 to Tl3939/59 (Gardener). 41 AARA.0216.0010; ARCH.0001.119.

8 Th e inadequacy of management information

19 Regulatory solvency

Insurance business in Australia may only be carried on by a company authorised to do so under the Insurance Act 1973. Within the HIH group there were three main authorised insurers: CIC Insurance Limited, HIH Casualty and General Insurance Limited and FAI General Insurance Company Limited. Following amendments to the Act which came into effect on 1 July 2002 1 general insurers must now comply with prudential standards determined by APRA2 but that requirement had not been

introduced at the time HIH failed. For prudential purposes, the principal constraint on HIH's authorised insurers was the requirement to comply with the conditions imposed by s. 29 of the Act. This included the requirement to maintain a prescribed excess of assets over liabilities (the minimum solvency requirement). 3

Any failure to comply with that requirement would not, of itself, have equated to commercial insolvenc/ but should have been as alarming, not least because of its relevance to the 'going concern' assumption in the preparation of the financial statements of HIH.

Three matters emerged in the course of the Commission' s inquiry which disclose that, even with no adjustments to their reported assets and liabilities, the authorised insurers in the HIH group were probably in breach of the minimum solvency requirement at various times.5 To the extent that a common theme emerges, it is that the requirement was regarded by some as a requirement of form rather than substance, without due heed to its underlying prudential purpose.

The three matters considered are:

• the treatment in the APRA returns of assets charged as part of the Cotesworth letter of credit arrangements (sometimes referred to during the Commission as the pledged assets issue)

• the netting-off of related company liabilities and receivables Ill the APRA returns

• the preparation of the September 1999 APRA returns.

19.1 The Cotesworth letters of credit

Under the system of regulation applicable in 1999 and 2000, it was an offence for a company to carry on insurance business without being authorised. 6

Where an entity

authorised to carry on insurance business was incorporated in Australia, its authority to do so was subject to the minimum solvency condition which required that the value of its assets should at all times exceed the amount of its liabilities by not less than the greater of:

Th e f ailure of HJH Insurance 9

• $2 million

• 20 per cent of its premium income during its last financial year

• 15 per cent of its outstanding claims provision as at the end of its last financial year. 7

An authorised insurer was required to lodge quarterly returns and yearly accounts with APRA8 and the yearly accounts were required to be audited.9 The required information was to include a statement of assets and liabilities having regard to the minimum solvency requirement.

Section 30( 1) of the Act provided that some assets could not be counted for the purpose of the minimum solvency calculation, including an asset 'charged for the benefit of a person other than the body corporate to the extent that it is so charged' . 10

After HIH acquired the Cotesworth group in 1998, arrangements were made for letters of credit to be issued to support the obligations of the Cotesworth syndicates. The letters of credit were secured by indemnities from companies within the HIH group, including the authorised insurers, supported to an extent by cash deposits or securities owned by the authorised insurers which were lodged with Austraclear Limited or with the Reserve Bank Information and Transfer System. Similar arrangements had been used previously by F AI to support its overseas operations.

In my view the effect of those arrangements was that the cash deposits or securities were 'charged for the benefit of a person other than the body corporate' within the meaning of s. 30(1)(c) of the Insurance Act, with the result that the authorised insurers were not entitled to count those assets for the purposes of the minimum solvency calculation.

During the negotiation of the letter of credit arrangements, the potential reaction of the regulator was expressly considered. 11 Ultimately, however, it was decided not to disclose the assets as being encumbered in the returns lodged for the period ending 30 June .1999. According to Frederick Lo, the view was espoused that the security arrangements in respect of the letters of credit were in the nature of a negative pledge 12, with the consequence that the cash deposits and securities in question were not 'caught' by s. 30. 13 Therefore, they were not required to be excluded in the minimum solvency calculations of the authorised insurers. For the reasons discussed below, I think that view, if it was held, was wrong.

In the case of one of the authorised insurers, CIC, it is likely that the exclusion of the charged assets in the solvency calculation for that period would have resulted in its failing to comply with the minimum solvency requirement. By 30 June 1999 CIC had provided a total of$154 million (face value) in cash deposits and securities. 14 Its returns lodged with APRA for that period showed net assets (less statutory exclusions) of $116 297 000 against a requirement pursuant to s. 29 of $99 158 000. 15 The evidence does not permit a precise calculation of the impact of excluding the charged assets, since $154 million was the face value of CIC's

10 Regulatory solvency

deposits and securities, not the market value as at 30 June 1999. Nonetheless, it is likely that the exclusion of those assets would have resulted in a substantial deficiency such that CIC would have been in breach of a condition of its authority to carry on business as a general insurer.

The total value of the letters of credit provided as funds at Lloyd' s 16 to support the Cotesworth operations as at 30 December 2000, the last reporting period before the failure of HIH, was £110 million.17 After the announcement of the appointment of the provisional liquidators on 15 March 2001, all of the securities held in support of the letters of credit were removed into the control of the security holders. 18 By the end of 2002 all of the letters of credit had been drawn down.19

It is a matter of speculation how events may have unfolded if the authorised insurers had not given the indemnities or made their assets available as security to the providers of the letters of credit. Nonetheless, if the question of the impact of those arrangements on the minimum solvency calculations had been approached with greater rigour by HIH and with due regard to the prudential purpose of the conditions imposed by s. 29, some or all of those securities may have been available to satisfy other liabilities of those entities. The ultimate effect of the arrangement was to deprive creditors in Australia of the benefit of assets which might have assisted HIH to meet its onshore liabilities. In that regard, the Cotesworth letter of credit arrangements are significant in the consideration of the circumstances surrounding the failure of the HIH group.

19.1.1 Section 30(1 )(c) of the Insurance Act

Section 30( 1) relevantly provided:

( 1) In this Part, a reference to assets of a body corporate does not include a reference to:

(c) an asset that is charged for the benefit of a person other than the body corporate to the extent that it is so charged;

( ca) where the whole or part of the undertaking, bu siness or property of the body corporate is subject to a floating charge, that undertaking, business or property to the extent that it is so subject.

The reference to ' a person other than the body corporate ' is clearly not intended to be a reference to the chargee, since all charges are, in that sense, for the benefit of another. If that had been the intention of the legislature, it would have been sufficient to say 'an asset that is charged'. Further, s. 30(1 )( ca) makes specific

separate provision in respect of floating charges, which would be unnecessary if the 'person other than the body corporate' ins. 30(1)(c) was the chargee.

Th e f ailure ofH!H Insurance 11

It seems to me that s. 30(1)(c) was intended to deal with assets securing third party guarantees and like obligations, so that the phrase 'charged for the benefit of should be understood to mean charged to secure or support the liabilities of a person other than the authorised insurer. In that context, the concluding words of the section ' to the extent that it is so charged' should be understood to refer to the sum secured by the asset. 20 I acknowledge that the section is not without its difficulties. It is not entirely clear to me whys. 30(1)(ca), assuming it is directed at charges given by an insurer to secure its own liabilities, refers only to floating charges and not also to fixed charges. Perhaps it was because of the difficulties in identifying when a floating charge would crystallise and thus have a direct impact on assets.

On the above construction, in my view, assets made available by the authorised insurers as security for the liabilities of the Cotesworth syndicates, providing they were 'charged' in the relevant sense, came within s. 30(1)(c) and were required to be excluded in the minimum solvency calculations of the authorised insurers to the extent of the sum secured (which, in this case, exceeded the total value of the security assets). As noted above, CIC failed the minimum solvency requirement (a condition of its authority) if those assets could not be counted.

19.1.2 Negotiation of the letters of credit

When the proposed acquisition of the Cotesworth group was raised with HIH's board in April 1998, it was foreshadowed that capital to support the underwriting activities would be established by letters of credit? 1 But the need for the authorised insurers to provide security does not appear to have been contemplated at that stage.

Negotiations with Westpac and Societe Generale Australia Limited for the issue of letters of credit in favour of Lloyd's commenced in around November 1998 and were conducted principally by William Howard and Lo. Their involvement (and that of others discussed later in this chapter) is summarised in the submissions of counsel assisting which I have reviewed and drawn on in the following discussion.

Involvement of Howard

During the negotiations, Howard expressly turned his mind to the issue whether assets pledged by the authorised insurers would have to be excluded from the solvency calculation by virtue ofs. 30 of the Act. 22 In correspondence with SocGen, he estimated the amount of security which one of the authorised insurers could provide without raising 'the ire' of the regulator23 and he sent SocGen a copy of s. 30.

24

In his submissions, Howard acknowledged that there was an issue about the treatment of the assets. He said he raised the matter with Dominic Fodera 'who stated that they did not have to be excluded'. The evidence relied on in support of that submission needs to be considered carefully. Howard gave evidence on two separate occasions of discussions with Fodera on the issue whether the pledged assets needed to be excluded in the solvency calculations. In July 2002 he gave evidence of a conversation shortly after 9 November 199825 which he identified as

12 Regulatory solvency

the reason for not disclosing the fact that the assets were pledged in the APRA retums. 26 He said the issue was raised with Fodera who took the view that the letters of credit were a contingent liability and that therefore the assets should not be excluded. 27 Fodera did not recall the issue being raised with him until July 2000. 28

In October 2002 Howard gave evidence of a later conversation with Fodera in relation to the effect of the letters of credit and the contention that they were charged assets. Howard testified that Fodera said that he was 'not of that view' (that they were charged assets29). Both conversations were relied on in Howard's submissions on the issue of his knowledge in 1998 and 1999. 30 However, the later conversation did not take place until 2000. 3 1 It is the earlier conversation that is relevant to Howard's understanding of the issue in 1998 and 1999.

The view attributed to Fodera in Howard's evidence of the earlier conversation discloses a level of confusion as to the precise issue raised by the letter of credit arrangements. It was inapt to describe the letters of credit as a contingent liability of HIH. They were a liability of the issuers, W estpac and SocGen. The indemnities given in support of the letters of credit would have constituted contingent liabilities, to be disclosed in the notes to the financial statements of the companies which gave them, but that was irrelevant for the purpose of the APRA returns. The view that Howard attributes to Fodera in 1998 resonates in the proposition that the authorised

insurers should not be penalised in their solvency calculations in respect of assets which secured only contingent liabilities. However, in the case of assets securing third party indemnities, that is precisely what s. 30 provided.

Counsel assisting submitted that there should be a finding that Howard knew or should have known in the second half of 1998 and in 1999 that the pledged assets ought to have been excluded from the solvency calculations of the authorised insurers. I do not think that I should make that finding. The evidence does not clearly establish that positive state of knowledge. I do think that Howard, having

identified the issue, should have taken greater care in its resolution. The need for due care and diligence is perhaps nowhere more acute than in the function of regulatory compliance and disclosure. The value of the assets in question was substantial. Howard appreciated that, depending on the way in which the issue was approached, it had the potential to cause the authorised insurers to be in breach of a condition of their authority to carry on insurance business. He went so far as to provide a copy of the relevant section of the Act to SocGen. He should have

apprehended the need for independent legal advice as to its proper construction and taken steps to obtain such advice.

However, as noted above, Howard's answer was that Fodera told him the assets did not have to be excluded. That would not, in itself, be a sufficient answer if the evidence disclosed . that Howard did not take due care in the way he presented the issue to Fodera for his consideration. The conversation Howard said he had with Fodera proceeded on a confused basis but the genesis of the confusion was not disclosed in the evidence. In the absence of evidence that Howard caused Fodera to be confused, or even appreciated Fodera' s apparent misapprehension of the real

Th e failure of H!H Insurance 13

issue which needed to be addressed, I do not think that I am in a position to make any further finding as to Howard's conduct.

Counsel assisting also submitted that I should find that Howard should have drawn the issue to the attention of the board or the audit committee. However, as noted in Howard's submissions, he raised the issue with Fodera who was a director and the person to whom Howard reported. That submission of counsel assisting is also rejected.

Involvement of Lo Lo acknowledged that he was aware, in November 1998, of the potential application of s. 30 to the letter of credit arrangements. Interestingly he, like Howard, also referred in that context to the proposition that the letters of credit constituted a contingent liability. 32

Lo said that his understanding at the time was that the assets provided in support of the letters of credit were subject to a negative pledge and were therefore not a charge over the assets as such. 33 His recommendation to Fodera was that, if they 'could go with the negative pledge route ... a charge will not be given over the assets, then it will not be caught by s. 30 ' .34 He thought that conversation must have occurred either before or soon after they signed the agreements. 35

Lo said he formed the view that the character of the arrangement between HIH and the banks was in the nature of a negative pledge from reading the terms of the agreement with the banks. 36 He was of the view that, under those arrangements, if the banks had to pay under the letters of credit they could call on HIH to pay them

but could not liquidate the investments that were set aside. 37 However, Lo later said a lot of his understanding was driven by talking to people at the time about what would happen if there was a call on the letter of credit (that HIH would first have an opportunity to deal with it). 38 He said that he probably did not really analyse the security provisions in the documents and that he was 'reading it probably more like a layman'.39

Lo said he understood that a negative pledge was something whereby HIH undertook not to do anything with the assets without Westpac' s agreement, whereas with a formal pledge Westpac itself had the right to sell the assets in the event of default. 40 He said that he had a 'cursory glance through the Austraclear documentation' 41 but did not recall its referring to a lodgment as creating an encumbrance or as creating a pledge.42

In fact, the relevant documents all described the security as a pledge or a charge. None ofthem described the security as a negative pledge. 43 Lo himself described the security as a pledge (not a negative pledge) in a paper for the board. 44 That paper omitted any reference to discussion of the potential impact of the arrangements on Insurance Act solvency which was, in my view, a material matter.

The proposition that the security arrangements amounted to a negative pledge is not tenable and it is difficult to understand how Lo came to that view. What troubles me

14 Regulatory solvency

most is his understanding of the remedy he believed was available to the banks if liabilities were not satisfied. His view that, if the letters of credit were drawn down, the banks could call on HIH to pay them, but could not liquidate the investments that were set aside, is inconsistent with the documentation he had before him. Further, it is uncommercial.

Counsel assisting and APRA submitted that Lo knew that the documents created a pledge and that I should reject his evidence that he believed the arrangement was in the nature of a negative pledge. In support of that submission they pointed to the following matters:

• The documents signed by Lo were expressed to be pledges and specifically created a charge.

• Lo had turned his attention to the requirements of s. 30 and was aware that the security requirements created a 'potential problem' .45

• None of the contemporaneous documents described the banks' securities as a negative pledge.

• Correspondence to him from Westpac and SocGen of 23 November 1998 described the security as a p1edge. 46

• He understood that under a pledge the bank had the right to sell on default, whereas under a negative pledge it did not. 47

• In the board paper for the meeting of 2 December 1998, which he said it was likely he prepared, the security was described as a pledge.48

The submissions made on behalf of Lo asked me to bear in mind that Lo is not a lawyer and had not practised as a public accountant since approximately 1984, and further that the security documents were lengthy and complex, having being drawn up by the financiers' lawyers. The fact remains that, in those circumstances, Lo did venture a view and indeed, as he recalled it, recommended to Fodera that, if they went with the negative pledge route, a charge would not be given over the assets and they would not be caught by s. 30.49

To accept the submission of counsel assisting and of APRA, I would have to think that Lo lied in his evidence about the view he formed. I should not make such a finding unless it were necessary in order to decide the questions of possible contravention of the Corporations Law for which counsel assisting contended. In my view it is not necessary to decide that question.

Counsel assisting first submitted that Lo might have contravened ss. 1309(1) or 1309(2) of the Corporations Law by failing to inform the audit committee or the board that the pledged assets ought to be excluded from the solvency calculations of the authorised general insurers. 50 The paper prepared by Lo certainly did not disclose the possible impact that the granting of the 'pledge' could have upon the authorised insurers whose assets were so pledged. Nor did the paper address which

The failure of HIH Insurance 15

enhttes within the HIH group would pledge assets in favour of W estpac and SocGen, or what the effect of such pledges might be upon satisfaction of the minimum solvency requirement of the Insurance Act. 5 1 I do not think that omission rendered false or misleading anything in the information provided to the board. Rather the board paper simply did not address the topic of the solvency

requirements under the Insurance Act. Accordingly I do not think that s. 1309 is engaged.

Counsel assisting also submitted that Lo might have contravened ss. 1309(1) or 1309(2) by telling Sandor Helby of Andersen that the arrangements were ' negative pledge style letters of credit'. If I were satisfied that Lo did make that representation to Helby, I would have to decide whether he believed it to be true. However, Helby did not give evidence before the Commission. Lo said he did not recall speaking to Helby. 52 The Andersen memorandum which states that 'the arrangements are referred to by Fred Lo (HIH Company Secretary) as negative pledge style letters of credit' 53 could well be a record of what Abela, or someone else in senior management of HIH, told Helby as to his understanding of Lo's views. I am not satisfied that Lo provided information to Andersen which could attracts. 1309.

I should add, however, that in 1998 and 1999 Lo had particular responsibilities in relation to this issue. On 13 November 1998 he considered how the 'potential problem' could be alleviated and advised Fodera that he did not propose to meet with the insurance commissioner or divulge any information to them in relation to the letters of credit. 54 He was the point of liaison between HIH and W estpac and SocGen for the negotiation of the terms of the facilities. Terence Cassidy and Fodera, as directors of HIH Casualty and General, resolved that Cassidy and Lo accept the offers from Westpac and SocGen and execute all ancillary indemnity and guarantee agreements and deeds to give effect to that acceptance to enable the issue of the necessary letters of credit. 55 Lo prepared the paper for the board meeting on 2 December 1998 describing the arrangements at a time when he had given consideration to the potential application of s. 30 to the security arrangements. No

legal advice was sought on the issue at this time, and nor were lawyers engaged to act on behalf of HIH in settling the terms of the securities. He signed the securities for the HIH subsidiaries.

On 22 November 1999 Lo and Cassidy signed the certificate required to be lodged under the Insurance Act in respect of the returns lodged by CIC for the financial year ending 30 June 1999. The form certified the correctness of notes forming part of the accounts required to be filed under the Insurance Act, including forms 102 and 103. Those forms did not disclose any statutory exclusions (other than for premiums outstanding for more than three months and non-approved related body

assets) and showed that the value of assets encumbered or charged was zero. 56 Lo 's evidence was that someone in the financial services division was responsible for preparing the form and he did not inquire whether CIC had given any encumbrances over its assets in favour ofWestpac or SocGen.57

16 Regulatory solvency

Counsel assisting did not submit that I should make an adverse finding against Lo in respect of his signing the certificate in November 1999 and accordingly I do not do so.

Involvement of Fodera

Fodera said that he was not aware in 1998 or 1999 of there being any issue as to whether assets secured in favour of Westpac or SocGen could be included in the authorised insurers' solvency calculations. As noted above, he said that was only brought to his attention in about July 2000. He could not recall any discussion between him and Lo between 1998 or 1999 as to the nature of the securities which were given to Westpac and SocGen at that time. 58

Fodera was prepared to assume that he received the note from Lo which referred to a proposal to 'alleviate the potential problem with the Insurance Commissioner' but he could not recall what his understanding was at the time of the potential problem that needed to be alleviated. 59

That evidence was corroborated by Lo, who at one point in his evidence said that he probably did not discuss ' the s. 30 assets' with Fodera but he did discuss with Fodera 'about the possible contingent liability of those letters of credit' and recommended to Fodera that he should discuss the matter with Andersen. 60 However, at other parts of his evidence Lo said that he did discuss the s. 30 issue with Fodera. 61

I accept Fodera's submission that the evidence concerning his involvement is not sufficiently certain for me to make a finding that he knew, prior to July 2000, that the pledged assets should have been excluded from the solvency calculations. 62 I also accept that I should not make a finding that Fodera should have raised the issue with Andersen and with the board or audit committee in 1998.63 Although he was clearly involved in some discussions, at least with Lo, the evidence of those discussions is too vague for me to find that the issue was posed for Fodera, in 1998 and 1999, in terms which should have prompted him to take any steps beyond those which his senior executives had seen fit to take.

64

I make no adverse findings about Fodera in respect of his conduct touching this issue in 1998 and 1999.

19.1.3 APRA return for the year ending 30 June 1999

The APRA returns lodged by CIC did not note the charged assets as statutory exclusions. 65 The returns showed that the recorded value of assets encumbered or charged and the amounts secured by an encumbrance or charge were zero. 66 They were signed by Lo and Cassidy.67

Th e failure ofHIH Insurance 17

Involvement of Cassidy Cassidy said that he understood from Lo that the securities were in the nature of a negative pledge.68 He conceded in cross-examination by counsel for APRA that, after he signed the agreement dated 25 November 1998 between HIH and SocGen69 , he was no longer of the view that the security held by SocGen was a mere negative pledge. 70

Cassidy said, however, that by the time he came to sign the APRA returns for June 1999 he , unfortunately, had lost track of what knowledge he had when the agreements were signed earlier and he relied on Lo that the returns were correct. 7 1

Cassidy submitted that the import of his evidence was not that he was unaware of the exclusion requirement at the time he signed the returns but rather that he may have signed a document without critically analysing its content, having accepted at the time that it had been prepared by the appropriate responsible officer of the company. 72

I do not think it is enough for a director in such circumstances to sign a statutory return such as those required to be filed with APRA without critical analysis. The very role of a director in signing such documents is to bring to mind relevant matters and to ensure they are disclosed appropriately. A responsible approach to formal disclosure processes (in this case processes that bear on the company' s very authorisation to carry on business) lies at the heart of an executive director' s responsibility. In the circumstances, Cassidy should have paid more attention to the APRA returns for the period ending 30 June 1999 when he signed them.

Cassidy should have brought to bear his own knowledge and understanding of the matters contained in the returns. He should have directed his attention to the integrity of the process by which the returns had been prepared and submitted to him for signature. His failure to do so resulted in his failing to observe a matter which, on his own evidence, had been within his knowledge.

19.1.4 Identification of pledged assets as an audit issue in 2000

Jonathan Pye of Andersen first became aware that the authorised insurers in the HIH group had provided security for letters of credit in favour of Lloyd's to support the business of the Cotesworth group in a conversation with Howard in June 2000. Pye became concerned that the security for the letters of credit might affect the solvency calculations of the authorised insurers. 73 The issue was taken up within Andersen by Helby who correctly identified the issue as being one of whether the assets pledged were excluded assets pursuant to s. 30. He obtained preliminary advice from Andersen Legal that, prima facie, the pledges would fall within s. 30. 74 Andersen

later calculated (and informed the board) that both CIC and FAI General would have a significant shortfall if the assets were excluded and that the total shortfall for the authorised insurers would be $80 million. 75

18 Regulatory solvency

Paul Abela was the person within HIH responsible for signing off on the APRA returns at that time. 76 He had assumed that responsibility in either late 1999 or early 2000. 77

His understanding, derived from discussions with Lo, was that the letter of credit securities were in the nature of negative pledges. That understanding changed when he was spoken to by someone from Andersen. 78 After that discussion, Abela obtained legal advice from both Minter Ellison and Mallesons Stephen Jaques.79 The legal opinions were to similar effect. On the basis of those opinions, Abela concluded that the better view was that the security arrangements did constitute a charge over the relevant assets for the purposes of s. 30.80

Abela said that he made 'that view' known to Fodera. 81 However, he did not say that he informed Fodera specifically of either the content or the existence of the ad vices themselves. Fodera said that he could not recall Abela telling him that he had received legal advice to the effect described by Abela in his evidence. 82 I accept the submission put on behalf ofF odera that the evidence does not sustain a finding that Fodera knew of the two legal advices obtained by Abela. 83

It is not clear precisely how the issue was first brought to Fodera' s attention in 2000. Fodera rejected the proposition that the issue raised related to the relevance to the solvency calculations of security being given over assets in support of letters of credit. He described the issue as Andersen (Pye or Buttle) querying how the accounting for the letters of credit should occur in the APRA returns. 84 As discussed above, to describe the issue in terms of the accounting treatment of the letters of credit misses the point. What is not clear to me is how that misapprehension arose and whether Fodera could reasonably have been confused.

Once the issue had been raised by Andersen, Fodera agreed to seek the views of an independent expert. 85 As discussed below, his misapprehension of the true issue identified by Andersen coloured that process.

19.1.5 Advice sought from Donald Findlater

On 25 August 2000 Fodera contacted Donald Findlater of KPMG and arranged a meeting which took place on 29 August. The way in which the issue was recorded by Findlater irt his notes of that meeting was that Fodera wanted to discuss 'treatment of letters of credit under the Insurance Act and how treated for solvency purposes'. 86

Findlater stated in evidence that his view at that stage was based on an assumption that the letters of credit arrangements secured liabilities disclosed on the same balance sheet, that is, the balance sheet of the entity which had put up the security for the letters of credit. 87 Fodera did not at any stage say to him that he (Fodera) was talking about letters of credit issued by an authorised entity in Australia to support

business underwritten by another entity in the group and it did not occur to Findlater at any stage that that might be a situation in respect of which his advice was sought. 88

The failure ofHJH Insurance 19

In those circumstances, Findlater said he assumed that for the purposes of APRA solvency calculations the outstanding claims provision would appear as a liability on the same balance sheet as the assets charged in support of the letters of credit. He took the view that, whatever a legal opinion might be about s. 30, in a realisti c calculation of the surplus of the authorised entity's assets over liabilities, the fact that both the liability and the asset appeared on the same balance sheet meant that you did not have to count the liability simply because the entity had issued a letter of credit in support of it. 89 Findlater's assumption was, of course, wrong. The letter of credit arrangement created no liability on the balance sheets of the authorised insurers that held the assets.

On 5 September 2000 Findlater sent an email to APRA in which he stated that hi s client sought clarification of APRA's 'interpretation and views as to how letters of credit should be treated for Insurance Act solvency purposes' .9° Fodera and Findlater met APRA on 20 September 2000. Their discussions on that date appear to have proceeded on the same misunderstanding (that the charges secured liabilities in respect of which full provision was made in the claims provision of the same entities). 9 1

Following that meeting, apparently as a result of discussions with Abela, APRA wrote to Fodera on 25 September 2000 expressing the tentative view that the pledged assets seemed to be excluded for solvency purposes92 and in a separate letter sought further information about the letters of credit. 93 In the first letter APRA specifically referred to s. 30(1)(c) but it also referred to s. 30(1)(ca), which deals with floating charges, and s. 30 (1 )(g), which deals with guarantees given to the authorised insurer.

The letter stated:

you [Fodera] mentioned at the meeting that any claim ansmg from business supported by the letters of credit would be fully provided as an OCP by HIH (i.e. one of the authorised entities .. . ).94

The tentative nature of APRA's conclusion that the assets were excluded for solvency purposes arose from APRA's agreement that in practice the capital requirement should not be doubled by both making the provision for claims and excluding the asset charged to support them. 95 It was the incorrect information that one of the authorised entities would fully provide for the claims arising from the business supported by the letters of credit that gave rise to the tentativeness in APRA' s conclusion. Fodera did not inform Findlater or Andersen of the correspondence from APRA96, nor did he correct APRA' s misconception.

Findlater provided a draft advice on 11 October 2000 which addressed the issue (irrelevant in the circumstances) of the quantum of capital that should be held against letters of credit. He did not address s. 30(1 )(c). 97 He was then asked to deal with s. 30(1)(c)98 , which he did in his final advice sent on 13 October 2000. 99

20 Regulatory solvency

Involvement of Fodera

An audit committee meeting was held between receipt of the draft advice (which did not deal with s. 30(1)(c)) and the final advice (which did). It appears the meeting was informed that Findlater had been asked to rewrite his advice to deal with secured letters of credit. 10° Fodera also informed the meeting that APRA had not given ' any meaningful comment or ruling' and in those circumstances Buttle said he would accept Findlater' s advice on the issue. 10 1

What Fodera did not do , however, was inform Findlater, the auditors or the audit committee that APRA had, since its meeting with him and Findlater, formed a tentative view that the assets were 'charged' (and so excluded) and had sought further information. 102 Nor did he tell them that APRA was under a misconception, which he had not corrected, that the authorised insurers whose assets were secured would provide fo r the claims.

Ignorant of these matters, Findlater's final advice stated only that APRA had not 'raised as an issue' the potential application of s. 30(l)(c).103 To compound the confusion, Buttle understood that sentence to mean that the matter had been discussed and that APRA did not see it as an issue.104 If Buttle had known the true position he would have delayed any determination of an audit opinion pending APRA' s consideration of the material sought 105 , which he saw as being relevant to

his assessment of the going concern assumption.

Fodera's submissions included a summary of the factual material adduced on this topic, concluding with the assertion that Fodera relied on the systems and procedures in place and, in particular, on the team headed by Abela to sign off on the APRA returns in November 2000 .106 That summary ignores the circumstances which led to Andersen's acceptance of Findlater's advice and, in particular, the events of the meeting of the audit committee on 12 October 2000 (before the APRA

returns were finalised) when the financial statements were approved.

For the reasons discussed earlier, I do not accept the submission of counsel assisting that Fodera was aware of the two legal advices obtained by Abela. 107

After some hesitation, I have decided not to make a finding that Fodera ought to have appreciated that the advice needed was legal advice as to the proper construction of s. 30(1)(c), rather than advice of an ' industry expert' . This was an issue of statutory interpretation of some complexity and importance. It cried out for

legal advice. It is noteworthy that the legal firms who provided an opinion on it got it right. Nonetheless, at least until APRA wrote to him, Fodera may still have been labouring under a misapprehension of the real issue. By that time the process of seeking independent advice was well under way. No one else who was interested in the subject raised a query about the type of advice that was needed.

Counsel assisting also submitted that Fodera deliberately misled Findlater as to the true position in respect of which advice was sought by omitting to tell him that the liabilities in respect of which the assets were pledged were not liabilities of the authorised general insurers but were the liabilities of other entities. However,

Th e f ailure ofHIH Insurance 21

Fodera's submissions have persuaded me that I should reject that submission. Fodera said that he explained to Findlater that the letters of credit included some issued on behalf ofHIH's Lloyd's syndicates managed by Cotesworth. 108 Findlater's email to APRA referred to general insurers writing business 'with Lloyd' s Syndicates in the UK' . 109 Whatever understanding Findlater drew from that information, I do not think that it can be concluded that Fodera deliberately misled Findlater as to the true position.

Finally, counsel assisting submitted that I should find that Fodera deliberately concealed from Findlater and Andersen the fact that APRA had not expressly approved the inclusion of the pledged assets but, to the contrary, had sought further information and documentation in respect of the letter of credit arrangements. Fodera' s submissions have persuaded me that the first part of that submission assumes an incorrect premise. As discussed above, Fodera did not represent to Findlater or Andersen that APRA had expressly approved the inclusion of the pledged assets. Rather, he informed Andersen and the audit committee that he had not received any meaningful comment or ruling from APRA. He did not say that he had received a letter from APRA. However, he did not say that APRA had expressed a tentative view that the assets were charged, and so excluded, and had sought further information. He did not say that the apparent reason for APRA' s tentativeness was a misconception that the authorised insurers whose assets were secured would provide for the claims. He did not say that he had not corrected that misconception.

By the time of the audit committee meeting on 12 October 2000 the additional information had not been provided to APRA.110

Involvement of Findlater Counsel assisting submitted that I should make a finding that Findlater' s conduct might have amounted to a departure from the standard of professional competence and due care required of a consultant auditor in the circumstances. For the reasons discussed in Section 1.3.5, it is not appropriate for me to embark on an inquiry of that kind.

Findlater's submissions acknowledged that, from a 'simple reading' of s. 30, it is clear that where an asset is charged for the benefit of a person other than the insurer and the charge secures a liability other than a liability of the insurer, the asset (to the extent of the charge) is not to be included in the assets of the insurer for the purpose of the minimum solvency calculation. 111 However, it appears that Findlater was at all times under the misapprehension that hi s advice was sought only in respect of letters of credit given in support of a liability of the insurer to its insureds. As noted above, Findlater's email to APRA refers to general insurers writing business 'with Lloyd ' s Syndicates in the UK'.It is surprising, in the face of that information alone, that Findlater did not consider the correctness of the assumption he made as to the circumstances in which his advice was sought. However, the position was complicated by the confused formulation of the issue by Fodera and I do not think anything further can be said on the issue.

22 Regulatory solvency

Involvement of Pye and Buttle

I make no adverse findings about Pye and Buttle. It was Pye who correctly identified the potential for the letter of credit arrangements to have an impact on the solvency calculations of the authorised insurers. He communicated the problem to the audit committee and identified the need for APRA approval and expert advice.

112 When, a month later, Fodera informed the audit committee that APRA had not given a meaningful ruling, Buttle determined to accept Findlater's advice. 11 3

I am aware of the evidence of the expert accountant retained by the Commission, Greg Couttas, that in his opinion Andersen did not obtain sufficient appropriate audit evidence. But I also accept the submission put on behalf of Andersen that it was a matter of professional judgment and that it was reasonably open to Andersen to come to a different view. 114

Both Pye and Buttle observed that Findlater's first advice did not deal with the right issue and had it sent back to be rewritten. Their reading of the revised advice in those circumstances was reasonable.

19.2 Netting-off

When the APRA returns lodged by the authorised insurers are compared with the statutory financial reports lodged with ASIC in 1999 and 2000, it appears that, in some instances, related company liabilities and receivables were set off against each other in the APRA returns. Under s. 30 of the Insurance Act related body assets were not permitted to be included in the minimum solvency calculation unless they were approved by APRA. By setting off related company liabilities and receivables, the authorised insurers understated their non-approved related body assets, with the result that net assets were overstated by the same amount.

There were instances where the authorised insurers wrongly netted off inter­ company indebtedness but the netting-off was apparent on the face of the returns lodged. Those returns, and the way in which they were dealt with by APRA, are discussed in Chapter 24 'The regulators'. In particular, I have noted in Chapter 24 that the regulator, too, appears to have been prone to ignore the importance of a strict application of the minimum solvency requirement. This section deals only with returns which did not disclose on their face that inter-company indebtedness had been netted off.

In the following three instances, the effect of the netting-off was that the authorised insurers appeared on the face of the returns lodged with APRA to meet the minimum solvency requirement when, according to the information in the statutory financial report, they did not.

Th e failure of HIH Insurance 23

19.2.1 CIC-period ending 30 June 1999

The annual APRA return for CIC for the period ending 30 June 1999 included form 102 (statement of assets and liabilities). 115 This form showed that CIC had net assets (less statutory exclusions) of$ 116 297 000. 11 6 This was $ 17 139 000 above CIC's minimum solvency requirement of $ 99 158 000 (being 20 per cent of premium income). 117

The form stated that CIC had no liabilities to related trusts and bodies corporate. 11 8 It stated that CIC's assets included investments of$ 67 818 000 in related trusts and bodies corporate. 119 Of this amount, $47 991 000 was not approved. 120 Assets approved under s. 30 totalled $19 827 000.121

Form 211 to CIC's annual return for the period ending 30 June 1999 reported that its related body investments comprised shares in unlisted companies ($48 487 000) and loans or other amounts owing by related companies to CIC ($19 331 000). 122

The financial statements of CIC, signed by Cassidy and Fodera on 15 November 1999, reported that CIC owed amounts to related bodies corporate totalling $33 943 000 123 and that amounts were due to it from related bodies corporate totalling $53 274 000. 124 The difference was $19 331 000, being the net amount disclosed in the APRA form 211 in respect of loans or other amounts owing by related companies to CIC. 125

If the liabilities of $33 943 000 to related bodies corporate had been disclosed as liabilities in the APRA return and not netted off for the purposes of the minimum solvency calculation, the return would have disclosed that CIC had failed to satisfy the minimum solvency requirements as at 30 June 1999.

Cassidy and Lo signed the form 100 certificate in relation to the APRA return. 126 The certificate was dated 22 November 1999. Andersen provided an independent audit report in respect of those accounts. The certificate was signed by Alan Davies as the approved auditor of CIC pursuant to the Act and dated 22 November 1999. 12 7

19.2.2 CIC-period ending 30 June 2000

CIC's statement of assets and liabilities (form 1 02) for the following year showed net assets (less statutory exclusions) of $137 268 000. 128 That amount was $46 304 000 above CIC's minimum solvency requirement of $90 964 000 (being 20 per cent of premium income).

129 The return for the period ending 30 June 2000 also

stated that CIC had no liabilities to related trusts and bodies corporate. 130

The form stated that CIC's assets included investments of $50 056 000 with related trusts and related bodies corporate. 13 1 Of this amount, $3 8 824 000 was not approved. 132 Assets approved under s. 30 therefore totalled $11 232 000. There were no approved loans to any related bodies corporate. 133

24 Regulatory solvency

Form 211 reported that the related body investments comprised shares in unlisted companies of $45 946 000 and loans or other amounts owing by related companies of $4 111 000. 134

The financial statements of CIC for the year ending 30 June 2000 were signed by Cassidy and Fodera on 30 November 2000. 135 Those accounts disclosed that at 30 June 2000 CIC owed $153 345 000 to related bodies corporate. 136 They also reported that amounts totalling $157 455 000 were due to CIC from related bod ies corporate. 137 The difference was $4 110 000, the amount of related company receivables shown in form 211 of the APRA return. 138

IfCIC's liabilities of$153 345 000 to related bodies corporate had been disclosed as liabilities in its APRA return and not netted off for the purposes of the minimum solvency calculation, the return would have disclosed that CIC failed to satisfy the minimum solvency requirements as at 30 June 2000.

Cassidy and Fodera signed the form 100 certificate in relation to the retum.139 The certificate was dated 11 December 2000. The audit certificate was signed by Buttle as the approved auditor pursuant to the Act and dated 11 December 2000. 140

19.2 .3 HIH Casualty and General Insurance-period ending 30 June 2000

The annual return for HIH Casualty and General for the period ending 30 June 2000 showed total net assets (less statutory exclusions) of$ 227 598 000 and net assets inside Australia of $ 190 062 000. 141 In the case of the total net assets, this was $ 115 099 000 above the minimum solvency requirement of $ 112 499 000 (being

15 per cent of the net outstanding claims provision). In the case of assets and liabilities in Australia it was $ 100 048 000 above the minimum solvency requirement of $ 90 014 000 (being 15 per cent of its outstanding claims provision). 142 The return stated that HIH Casualty and General had no liabilities to related trusts and bodies corporate. 143

The form stated that HIH Casualty and General's assets included investments of $ 549 988 000 in related trusts and bodies corporate in Australia and $ 14 077 000 of investments in related trust and bodies corporate outside Australia. 144

Of these amounts, $ 268 212 000 inside Australia and $ 14 077 000 outside Australia was not approved. 145 The amount of loans to related bodies corporate which were approved by APRA was$ 167 089 000. 146

Form 211 disclosed that the amount of $ 549 988 000 of investments in related trusts and bodies corporate inside Australia comprised $ 484 285 000 of shares in unlisted companies and $ 65 703 000 of loans or other amounts owing to HIH Casualty and General by related bodies corporate. The related body investment of

$ 14 077 000 outside Australia consisted of loans or other amounts owing to HIH Casualty and General by related bodies corporate. 147

Th e failure ofHJH Insurance 25

The financial statements of HIH Casualty and General for the period ending 30 June 2000 were signed by Cassidy and Fodera on 30 November 2000. 148 The financial statements reported that the company owed $ 429 558 000 to related bodies corporate. 149 They also reported that amounts totalling $ 509 952 000 ($ 299 871 000 current and $ 210 081 000 non-current) were owed by related bodies corporate to HIH Casualty and General. The difference between the reported amounts owed by related bodies corporate to HIH Casualty and General and amounts owed by it to related bodies corporate is $80 394 000. The total amount shown on the APRA return as being amounts owing by related bodies corporate was $ 79 780 000.

If the liabilities of $ 429 558 000 to related bodies corporate disclosed in the financial statements had been disclosed as a liability in the APRA return and not netted off for the purposes of the minimum solvency calculation, the return would have disclosed that HIH Casualty and General failed to satisfy the minimum solvency requirements as at 30 June 2000.

Fodera and Cassidy signed the form 100 certificate in relation to the return. The certificate is dated 11 December 2000.150 The audit certificate was signed by Buttle as the approved auditor and dated 11 December 2000. 151

19.2.4 Summary of evidence

HIH's practice of netting-off the inter-company balances against each other in the APRA returns for the authorised insurers appears to have been a longstanding one. 152 It does not appear to have been questioned until the middle of 2000 when Richard Phillip of APRA pointed out to Abela that if HIH did not net off its inter­ company indebtedness, the authorised insurers were at risk of failing the solvency test. 153

The person responsible for the preparation of APRA returns in late 1999 when the returns for CIC and HIH Casualty and General for the period ending 30 June 1999 were lodged was Peter Duesbury. However, he did not assume that role until late September 1999.154 In relation to the 30 June 1999 return for CIC, he did not prepare the return, nor did he personally review it. He left the review to the auditors.155 Duesbury's evidence was that he was not aware when that return was compiled that the figure for inter-company indebtedness (assets and liabilities) had been arrived at after netting-off liabilities owed by CIC to its related bodies corporate. 156 Duesbury had not had any discussion with either Cassidy or Lo before they signed the certificate that accompanied the return. 157 Dues bury did not discuss with anybody the question whether it was appropriate to net off the inter-company indebtedness for the purpose of compiling the APRA returns. 158

In respect of the returns for the period ending 30 June 2000, the person then responsible for the preparation of APRA returns was Abela. Abela understood that HIH had always prepared its returns on the basis that inter-company liabilities and receivables were netted in determining which assets were to be counted for the

26 Regulatory solvency

purposes of s. 30. He did not question the appropriateness of that practice until his discussion with Philip in the middle of 2000, referred to above. 159

Pye's evidence was that he was not aware that any netting of inter-company indebtedness had occurred in the 30 June 1999 APRA return for CIC. 160 He also gave evidence that he never discussed with anyone from HIH that the APRA returns had been prepared on that basis. 16 1 Pye said that, as part of the year-end close process, HIH would tidy up its inter-company accounts in the ordinary course to reduce them to minimum balances. 162 Pye said that he was unaware of any netting process undertaken in respect of HIH's APRA returns and had not discussed the question with Abela or anyone else from HIH. 163 Pye also gave evidence that Alan Docherty had the responsibility within Andersen for comparing the APRA returns with the statutory accounts of the HIH authorised insurers in 2000. 164 Docherty would have reported to John Fanning or one of the other Andersen managers, but Pye was not aware whether Docherty did or did not observe the inter-company netting and the discrepancy between the statutory accounts and the APRA returns. 165 Pye had not seen any documents in the Andersen work papers addressing the question of netting. 166 Pye's evidence was that the adjustment of the inter-company

balances, which he considered could occur, could be done by 'a round-robin of settlements,' even without the making of actual repayments between the various companies in the HIH group. 167

Buttle agreed that the netting of the inter-company balances described above had occurred in the APRA return of CIC for the year 2000 which he signed. 168 His evidence was that he was not aware when he signed the audit report for the APRA return that the netting-off process had occurred because he had not compared the APRA return with the annual return of CIC. 169

Buttle' s evidence was that, although he was not aware of the netting-off at that time, he regarded it as legitimate because 'effectively those related party accounts could be regarded as being nettable and netted'. 170 Although Buttle agreed that the gross figures for the inter-company assets and liabilities were contained in the statutory accounts of the authorised insurers, he expected that those accounts 'would have been netted physically by journal entry prior to the preparation of the APRA returns' . 171 For that reason, Buttle did not turn his mind to the question whether they had or had not been netted in fact. 172

Buttle did not agree that it would be necessary to net the amounts physically prior to the year end rather than prior to the lodgment of the relevant returns. 173 Buttle regarded it as a ' normal situation ... to clear the inter-company accounts'. 174

He

considered that the HIH group 'had the power to do the set-off and therefore the set­ off was appropriate' .175 However, Buttle also agreed with the proposition that the interests of external creditors would need to be considered before the netting-off process he described could properly occur. 176 Buttle was unsure whether, if the netting-off process had been drawn to his attention before he signed the relevant APRA returns, he would have been content with the netting treatment of the inter­

company balances. 177

Th e failu re ofHIH Insurance 27

Buttle agreed that paragraph 4.4 of AASB I 033 only permitted the set-off of debtor and creditor balances when the entity had a legally recognised right to such a set-off and intended either to settle on a net basis or to settle physically.178 He also agreed that the facts would not have permitted CIC or HIH Casualty and General to net off their inter-company receivables in accordance with that standard without further analysis. As far as Buttle was aware, that analysis was not done. 179

Davies gave evidence that if netting-off of the inter-company indebtedness had occurred in the APRA returns, he was not aware of it. 180 He also agreed that so far as he was aware no one sat down with the accounts of CIC for the year ending 30 June 1999, compared the inter-company liabilities balance shown in its annual accounts with the APRA return and noticed the discrepancy.18 1 Davies said he could understand how that might have happened and that it was possible that Andersen had different people undertaking the work on the audits of the financial statements and the APRA return respectively. He also suggested there was 'a timing question as to which got produced first '. 182 Davies was unable to say whether the approach adopted by Andersen in respect of the returns (which was described in Veronica Henderson ' s note in October 1998 183 ) would or would not have been likely to detect the fact that netting-off of the inter-company balances had occurred.184

19.2.5 Submissions and findings

Counsel assisting submitted that I should find that Andersen signed audit certificates for the relevant APRA returns which were false and thereby breached the requirements of s. 47 of the Insurance Act. 185 However, as noted in Andersen's submissions, although there is an apparent inconsistency between the financial statements and the APRA returns, the evidence does not permit me to conclude that

. . 186

the APRA returns were mcorrect.

The fact remains that the financial statements and the APRA returns cannot both be correct. They were both prepared as at the same balance date, namely 30 June 1999. Either the process of setting-off, payment or other form of discharge that is a necessary precursor to the exercise of netting-off was, or was not, done at 30 June

1999. Those assisting the Commission have not located any document recording payments or discharges, nor have they located journal entries evidencing a set-off. No witness gave positive evidence of the existence of journal entries and none was produced.

If the financial statements are correct, the exercise of netting-off was not done. If this is correct, the APRA returns would also be incorrect. As I understand the argument advanced by Andersen, the possibility remains open that journal entries were passed after the financial statements had been completed but before the APRA returns had been prepared. In my view, even if that were the case it would make no difference. Journal entries do not create rights. Rather, they evidence or reflect rights that have otherwise arisen. Under AASB 1002 (the apparent attitude of Andersen to which is the subject of comment elsewhere in the report) unless the

28 Regulatory solvency

process of setting-off, payment or other form of discharge had occurred as at 30 June 1999, journal entries passed after balance date could not alter the position.

The other possibility is that the process of setting-off, payment or other form of discharge had been done as at 30 June 1999 and either the relevant journal entries were passed but were overlooked at the time the financial statements were finalised or those journal entries were created later when the oversight was detected. In that case the APRA returns would be correct and the financial statements would be wrong. If that is so, it is curious that no steps were taken to correct the financial statements which, after all, are documents of public record.

In my view, the possibility that the process of setting-off, payment or other form of discharge was done as at 30 June 1999 is not strong. On the state of the evidence, the possibility that relevant journal entries exist is remote. Nonetheless, I suppose the possibility exists. This makes it difficult to conclude, definitively, which of the two sets of documents was incorrect. HIH had a statutory obligation to file both documents and each was certified as being correct.

In the circumstances I do not make a finding of the nature contended for by counsel assisting. It is unfortunate that Andersen did not, so it appears, make the simple comparison between the financial statements and the statutory returns which would have disclosed the practice earlier. It is unfortunate that nothing came of the issue when it was identified by Philip in mid-2000.

Netting-off-a cautionary note I do wish, however, to say something about the practice of netting-off. Inter­ company indebtedness is not merely notional, and it should not be treated as such in the preparation of financial statements and statutory returns. The law does not permit debtor and creditor balances to be set off against one another in the absence of a legally recognised right of set-off. If, as I suspect, a practice evolved within HIH which disregarded that fundamental proposition, that practice is to be condemned.

This is an issue which, I suspect, extends beyond general insurers. There is more to netting-off within a group than merely 'tidying up' the balance sheet. The problems may not be as evident where there are class orders or cross-guarantees within a group. But as a general rule third parties deal with particular entities, not with a group. In the process of netting-off, regard must be had to the effect, if any, that the assumption or discharge of liabilities (which is a concomitant of the process) could have on the interests of third parties.

The failure of HIH insurance 29

19.3 The September 1999 quarterly returns

I said at the start of this chapter that the minimum solvency requirement appears to have been regarded within HIH as a requirement of form rather than substance and that its underlying prudential purpose does not appear to have been given due regard. Perhaps the most disturbing demonstration of that attitude disclosed in the Commission's inquiries was in the manner in which the quarterly returns for the period ending 30 September 1999 were prepared. The Commission's inquiries in respect of those particular returns were prompted by an email produced to the Commission which stated:

The APRA returns lodged for the September 99 quarter were prepared on the back of an envelope, so to speak. This was due to the conversion of the F AI trial balance, the investment system plus solvency issues. This forced us to include a number of pencil entries and assumptions as set out below.187

The email was sent by Duesbury to Howard on 23 November 1999. Duesbury was responsible for the preparation of APRA returns at the time the returns for the September quarter were due to be completed, but he had only held that position for a very short time. He took up the position at the end of September 1999 and was in the process of transferring to a new position by the end ofNovember. According to his submissions, he stayed to assist in the preparation of the September quarterly returns 'out of courtesy to Mr Howard' .188 It was in that context that he sent the email to Howard setting out details in respect of the preparation of those returns. 189

The 'pencil entries' made in the preparation of the September 1999 quarterly returns demonstrate that people within the financial services division of HIH were prepared to manipulate the information disclosed to the regulator to ensure that the minimum solvency requirement was complied with by the authorised insurers.

This was essentially a failure of governance. Duesbury's submissions referred to his role as a 'line executive in the process of producing APRA returns' .190 The submissions also resisted the proposition that the contents of the email were 'some composition by Duesbury' and asserted that the email simply transmitted information from the investments department which Duesbury compared with information in the general ledger. The submission did not squarely address the contention of counsel assisting that the email shows that HIH manipulated the reported liabilities of its authorised insurers to ensure that they met the statutory solvency requirements under the Insurance Act. In my view that is what HIH did.

As with some other 'middle management' witnesses, Duesbury played down his responsibility in these events. But if Dues bury assumed as little responsibility as he asserted for these incidents, that was wrong. He should not have prepared a document for others that he would not, if required, have been prepared to sign himself.

There was no evidence as to whether the approach to the preparation of the September 1999 quarterly returns was different from the approach taken in respect

30 Regulatory solvency

of other returns. APRA submitted that it was only because Duesbury's email of 23 November 1999 came to light in the Commission' s review of HIH's back-up tapes that the falsity of the September 1999 returns was revealed. 191 That is true. APRA went on to submit that it could be presumed that this was not the only instance of such deception. I cannot, however, substitute such speculation for evidence. The items in Duesbury's email to Howard which caused me the most concern are discussed below.

19.3.1 Smoothing of outstanding claims liability

As noted above, Duesbury' s email stated that those who prepared the returns were 'forced' to include a number of 'pencil entries'. In relation to F AI General the email stated:

The outstanding claims were adjusted to smooth the impact of MIPIIALAS claims. Effectively reducing outstanding claims by $34.0 M.

The pencil entry noted to 'smooth' the impact of those claims was a debit to 'outstanding claims liability' and a credit to 'profit and loss'. Duesbury explained in his evidence that a 'pencil entry' was a 'pencil electronic entry' since the accounting records of the group were maintained electronically. 192 He said that a pencil entry referred to in his email was an entry that 'hadn't made it into the general ledger at that point in time'. 193 However, the entry was never made in the general ledger. 194 It was asserted in Duesbury's submissions that, if he had remained within the financial services division, he would have seen to it that the adjustments referred to in the email were carried forward but that he was not in a position to do so as he was no longer part of that division. 195 In fact the outstanding claims liabilities for MIPI and ALAS were required to be substantially increased, not reduced.

The provision for outstanding claims liabilities disclosed in the APRA return was the figure recorded in the general ledger, adjusted downwards by $ 34 million. Dues bury explained 'smoothing' as a process of aligning results with the budget. He described it as more a management tool than an external reporting tool. He said that

'if there was any large impact at the beginning of the year, it was amortised over the year' . 196 He conceded that an adjustment to 'smooth' the impact of an increase in reserves would have had the effect of reducing the outstanding claims liability of F AI General as at 30 September 1999 with the result that outstanding claims liabilities would be falsely stated as at that date.

197

Duesbury said that he was instructed by Fodera to make the entry debiting outstanding claims liability and crediting profit and loss. 198 Fodera had no recollection of giving that instruction. He suggested that Duesbury misunderstood an instruction to record the entry correctly in the APRA return by including both the $ 34 million liability and an offsetting recovery in the sum of $ 34 million from Hannover Re. 199 I accept that Duesbury may have misunderstood the instruction he was given by Fodera but that provides no justification for his acting as he did on the instruction as he understood it, which was to produce a false return.

Th e failure of HIH Insurance 31

Counsel assisting submitted that I should find that Duesbury acted dishonestly in effecting the pencil adjustments in respect of the $ 34 million 'smoother' to the F AI accounts since he knew its result was to make a false statement in respect of outstanding claims liability as at that date. Duesbury's submissions advanced a number of reasons why I should not make that finding. 200 In particular, he submitted that there were too many issues surrounding the adequacy of reserves at that time. I accept that Duesbury was operating in difficult circumstances, particularly including the fact that he was responsible for the APRA returns for only a very short period. Nonetheless, I am satisfied he understood that the effect of the $ 34 million adjustment to outstanding claims liabilities was that those liabilities were falsely understated in the quarterly returns to APRA. It was not a question of resolving uncertainties. It was a question of the nature of a 'smoothing' entry in a statutory return. A statutory return is not the place for using management tools to bring results in line with budget. It is the place for full and frank disclosure of the true financial position of the regulated entity. Dues bury was, if only for a short time, the person responsible for preparing that disclosure.

Duesbury was not an officer within the meaning of the Corporations Law and it is not suggested that he might have committed any offence. However, in my view, he participated in a process of manipulation of financial information required to be disclosed to the regulator. That was an undesirable corporate governance practice.

Howard conceded that there was no legitimate basis for smoothing the F AI General MIPI/ ALAS results. Counsel assisting submitted that, in failing to correct the 'pencil' adjustments or to bring them to Fodera or Lo's attention, Howard might have failed to discharge his duties with care and diligence and so might have acted contrary to s. 232(4) of the Corporations Law. But there is insufficient evidence that Howard was an officer ofF AI General Insurance Company. Had I been satisfied on that point, I would have found that he might have contravened s. 232(4) but because of the doubts as to his status as an officer, I do not find that Howard might have breached the law in this respect. That having been said, I make the same comment as I did in relation to Duesbury. Those who had the responsibility to sign the returns were entitled to expect more from those involved in the presentation of the documents to them.

19.3.2 HIH Underwriting and Insurance (Australia) Pty Limited

In respect ofHIH Underwriting and Insurance, Duesbury's email stated:

The bonds held in U&I to protect solvency were so ld and the funds banked to CIC $ 8.4M. To correct this the following entry was made.

The pencil entry described was a debit to 'bank' and a credit to 'intercompany CIC'. Duesbury's evidence was that the cash was banked to the wrong account. 201 He acknowledged that he understood that if HIH Underwriting and Insurance did not have $ 8.4 million of cash, but was instead owed that money by a related company, the inter-company receivable would be an excluded asset for the purposes of solvency calculations in the absence of APRA approval. 202 He also agreed that, if

32 Regulatory solvency

the return had been prepared in accordance with the company's books, it would have shown that HIH Underwriting and Insurance did not meet the solvency requirements. He said that he had discussions with Howard on that issue before he sent the email. 203

Duesbury agreed that the statement in the APRA quarterly return that the company had cash assets of $ 8.45 million was false and that he appreciated that prior to 26 November (when the return was signed by Lo).Z 04 Again the 'pencil entry' was one made for the purposes of the APRA return only and did not reflect the company's books. 205 The company's books showed that HIH Underwriting and Insurance was in overdraft in its bank account and that it was owed $ 8.5 million by a related entity.Z06

Counsel assisting submitted that, in circumstances where Duesbury knew that HIH Underwriting and Insurance would be statutorily insolvent if the return was prepared in accordance with the general ledger, I should find that he acted dishonestly in effecting the pencil entires in that instance. It was submitted for Duesbury (without supporting references) that Duesbury's evidence was that he did

not at the time know that the statement in the return that the company had cash assets of$ 8.45 million was false. 207 In fact his evidence was that he thought he did appreciate at the time that the statement was false. 208 This discloses that the statement of assets of HIH Underwriting and Insurance was deliberately manipulated so as to give the appearance that it complied with the minimum solvency requirement when in fact it did not. That is a practice which I roundly condemn.

19.3.3 Notional transfer of securities to CIC

In relation to CIC, the email stated, 'To improve the solvency of CIC, Semi Government bonds and unit trusts were notionally transferred from C&G'.

The email set out the journal entries or pencil entries in respect of that transaction which, importantly, included crediting 'intercompany C&G' in the sum of $ 70 million. The email from Duesbury to Howard expressly states that the purpose of the notional transfer was to improve the solvency of CIC. Dues bury testified that he was not aware at the time that no assets were in fact transferred.

209 Counsel

assisting submitted that I should reject that evidence.210 Duesbury's submissions in response contended, amongst other things, that the purpose of the email was for Duesbury to pass on suggestions to his superiors and that it was a matter for his superiors whether those suggestions were adopted or effected. The submissions stated that Duesbury acted simply as a conduit through which information flowed. If that is the case, in itself it establishes that Dues bury did not discharge his duties with care and diligence. As noted above, Dues bury was not an officer of CIC and I do not suggest that he might have committed an offence. However, it goes without saying that the practice of manipulating financial information required to be disclosed to the regulator is entirely unacceptable.

The failure ofHIH Insurance 33

19.4 Possible contraventions and referrals

In this section I set out the findings I have made about matters that might have been a breach of the law in relation to the subjects considered in this chapter. I also note those matters that, in my opinion, should be referred to ASIC for further consideration.

19.4.1 Arising from Section 19.1.2

Lo Section 19 .1.2 deals with Lo' s involvement in the negotiation of the letter of credit arrangements to support the Cotesworth operations. I have already stated that I do not accept counsel assisting's submission that I should find that Lo might have breached s. 1309(1) or s. 1309(2) of the Corporations Law.

The question that does, however, arise is whether Lo might have breached s. 232(4) (in relation to conduct before 13 March 2000) or s. 180(1) (after that date). In my view, Lo failed to give adequate attention to the question of whether the assets of authorised insurers that were pledged to Societe Generale or W estpac were caught by s. 30, and he failed to take legal advice on that question. He also failed to raise the matter for the consideration of the board in his paper of December 1998, although he knew it was important.

If, as Lo testified, he believed the assets were subject to a negative pledge, I am satisfied that he failed to exercise the care and diligence to be expected of a company secretary in the company's circumstances. In forming that belief, he would have failed to consider the terms and implications of the documents he signed and the correspondence he read. If, as was said on his behalf, he did not understand the implications from those documents because he was not a lawyer, he should have sought legal advice.

On the basis of those findings Lo might have contravened ss. 232( 4) or 180(1) of the Corporations Law. Because the functions of regulatory compliance and disclosure are not mere matters of form, but are central to the conduct of a viable insurance industry, departure from the standard of due care and diligence in that area is a serious matter and warrants attention.

I recommend that this matter be referred to ASIC for consideration of whether civil penalty proceedings should be instituted against Lo.

19.4.2 Arising from Section 19.1.3

Cassidy

Section 19.1.3 deals with Cassidy's signing ofthe June 1999 APRA returns after the letter of credit arrangements had been entered into. A question that arises is whether Cassidy's conduct-described in Section 19 .1.3-might amount to a breach of s. 232(4) ofthe Corporations Law.

34 Regulatory solvency

If, as I have found, Cassidy:

• failed to analyse carefully the June 1999 APRA returns at the time he signed them when

the returns failed to note the charged assets as statutory exclusions

and

Cassidy was no longer of the opinion that the security was a mere negative pledge

then, in my view, Cassidy might have breached s. 232(4) of the Corporations Law.

For the reasons identified in relation to Lo, I recommend that this matter be referred to ASIC for consideration of whether civil penalty proceedings should be instituted against Cassidy.

19.4.3 Arising from Section 19.1.5

Fodera

Section 19.1.5 deals with Fodera's dealings with the board in October 2000 in respect of the Cotes worth letter of credit arrangements. On the basis of the findings I have made in Section 19.1.5, Fodera furnished information to the directors and the auditors at the audit committee meeting. The information was that APRA had not given any 'meaningful comment or ruling' on whether the charged assets should be excluded. That information was misleading: Fodera omitted to mention that APRA had since formed a tentative view that the assets were charged and therefore to be excluded from the solvency calculation and was awaiting the provision of further material from HIH. This was a material matter.

Fodera does not appear to have taken any steps to bring the omitted material to the attention of the directors and auditors or otherwise to cure the misleading nature of the information. On this basis, Fodera might have contravened s. 1309(2) of the Corporations Law. Alternatively, he might have breached s. 180(1) of the Corporations Law.

Again, this is a significant matter. It pertained to the relationship between an authorised insurer and the regulator in respect of a condition of the insurer's authority to carry on business. That authority was relevant to the preparation of the group ' s accounts for 30 June 2000 on a ' going concern' basis.

I recommend that this matter be referred to ASIC for consideration of whether to institute proceedings under s. 1309(2) or civil penalty proceedings under s. 180(1).

The failure of HIH Insurance 35

4

6

9

10

II

12

13

14

15

16

17

18

19

20

21

22

23

24

25

26

27

28

29

36

The amendments were effected by the General Insurance Reform Act 2001 .

See Insurance Act 1973, s. 32 .

The section also imposed a condition in respect of arrangements for reinsurance which is not relevant to this discussion. Section 29 was repealed by the General Insurance Reform Act 2001; a different solvency test is now contained ins. 28 of the Insurance Act 1973.

The relationship between Insurance Act solvency and the commercial test of solvency was discussed in Background Paper No. 15 'The assessment of the insolvency of a general insurance company', prepared by those assisting Commission: See CORE.054.001.

See Chapter 20 'Effects of incorrect accounting' in which the conclusion is reached that with adjustments HIH Casualty & General and FAI breached the minimum solvency requirement.

Section 21 (2) of the former Insurance Act 1973.

Section 29(1 )(b).

Section 44 .

Section 47.

Section 30(l)(c).

SGHA.0021.001; SBB.l58.311_001.

T11389/29 to T11389/31.

T11391/20 to T11391!25 .

WITS.0108.001 (Franco) and exhibit 5 to that statement: WITS.Ol08.014.

APRA.0229.0045 at 0047.

Security for the ability of the corporate capital vehicle to meet its liabilities as a member of the Lloyd ' s syndicate should the syndicate incur losses: WITS.0001.001 at 005 par. 9 (Riddell). WITS.0001.001 at 006 par. 13 (Riddell).

WITS.Ol08.001 at par.4 (Franco).

WITS .0295 .001 at 002 par.6 (Riddell).

A contrary view was put by Andersen in their reply to the pledged assets issues paper: WITS.0225 .004 at 074 to 077 pars 168.1 to 168.2 .

BRD.031.016 at 018 .

Tl0464/41 to Tl0464/49.

SGHA.0021.001

SGHA.0021.003

T10463/14; Tl0465110 to TI0465111.

Tl0464/50 to T10465/ 10.

Tl 0464/51 to Tl 0465/11. T13634/50 .

T16473/37 to Tl6473/39.

Regulatory solvency

30

SUBP.003 1. 001 at 053 par. Q.33 and supplementary submission at SUBP.Ol 03.001. 31 T16472/56 (Howard). 32

Tll391/27toT1 1391/32. 33 Tll389/25 to Tl 1389/31. See also Tll39811 9 to Tl1398/22 ; Tl1406/19 to Tll406/28 ; TI8408/46 to Tl8408/52. 34

Tl1391121 to T11391/25 . 35 T 18424/49 to Tl8424/51. 36

Tl1406/30 to Tl1406/34. 37 Tl1407/8 to Tl1407110. 38

Tl8411 /32toT1841 1/36 . 39 TI8413/28 to Tl8413/45 . 40

Tl1388/27 to Tl1388/38; Tl841 0/49 to Tl841 1154. 41 Tl1388/55 . 42

TI1389/2 to TI1389/9. 43 APRA.0046.0034; APRA .0046.0101. 44

BRD.041.006, Tl1392/9 to T11392/29. 45 Tll39 1120 to TI1391/44. 46

APRA.0046.0101; SBB.158.299_001. 47 SUBM.0026.001 at 013 par.44. 48

SUBM.0026.001 at 014 par. 47. 49 Tl139 1121 to Tl 1391/25. 50

SUBM.0026.00 1 at 043 par. 152. 51 BRD.041.006. 52

Tl8407/40 to Tl8407/51. 53 AARC.0013.011. 54

SBB .158 .311 001. 55 SBB.002.077 001. 56

APRA.0229.0038; APRA.0229.0045; APRA.0229.0049. 57 T 18422/42 to Tl8423/52. 58

Tl3634/45 to Tl3635/22. 59 Tl3635/31 to Tl3636/22. 60

TI1389/41 toT1 1389/49. 6 \

Tll393/48 to Tl1394/4; Tl1394112; Tl1394/43 to Tl139511 5; TI 8424/41 to TI8424/51. 62 SUBP.0054.001 at 035 pars 7.2 and 7.3. 63

SUBP.0054.00 1 at035 par. 7.4. 64 See SUBP.0054.00 1 at 035 par. 7.4 . 65

APRA.0229.0045 at 0047 .

Th e failure ofHIH Insurance 37

66

APRA.0229.0049. 67 APRA.0229.0038. 68

T14474/17 to T14475/8. 69 APRA.0046.0129 70

T14477/10 to T14477/ 15 . 71 Tl4478/ll to T14478/15 . 72

SUBP.0050.001 at 003 par. 1.1.2. 73 WITS .0225.004 at 048 par. 136. 74

AARC.0013 .011 at 012; see also AND.6135 .0413 . 75 BRD.059.027 at 039. 76

T13640/58 to T13641/2 (Fodera). 77 Tll459/48 to T11459/52 . 78

T11466/43 to T11467/37. 79 TEND.0031.001; TEND.0031.003 . 80

Tll469/16toT11469117. 81 Tll469/22 to T11469/23. 82

T13643/16 to T13643/32 . 83 SUBP.0054.001 at par.7.7. 84

T13639/35. 85 T13644/33 . 86

WITS .Ol51.009. 87 T11272/16 to T11272/23. 88

T11273/8 to Tll273117. 89 Tll275/8 to Tl l 275 /32. 90

AND.l668.0007.0008. 91 See SBA.083.688_001. 92

SBA.083 .688_001. 93 APRA.0007.0126. 94

SBA.083 .688_001 at 688_001. 95 SBA.083.688_001 at 688_002. 96

T13654/16 to T13654/42. 97 AND.l913.0006. 98

T11284/59 to Tll285/7. Rob Martin denied that he was the person who made that phone call: T15929/4 to T15929/7 and T15931/13 to T15931/20. 99 AA.0004.0001.0159.

100

AND.6032.0157. 101 ABB.Ol20.0 17at018. 102

In the two letters of25 September 2000: SBA.083 .688_001; APRA.0007.0126.

38 Regulatory solvency

103

AA.0004.0001.0159. 104 T17182/47toT17182/50. 105

Tl7187/35toT17187/42 . 106 SUBP.0054.001 at 037 to 038 par. 7.9. 107

SUBM.0026.001 at 041 par. 145.1; SUBP.0054.001 at 037 par. 7.7. 108 WITS .OI62.001 at 061 par. 10.1.4. 109

AND.1668.0007.0008. 11 0 APRA.0102.0074 at0076. 11 1

SUBP.0027.001 at 001 par. 5. 11 2 WITS.0225.004 at 048 par. 136; BRD.059.027 at 039. 11 3

ABB .0120.017 at018. 11 4 SUBP.0077.001 at003pars9to 10. 115

APRA.0229.0045. 11 6 APRA.0229.0045 at 0047. 117

APRA.0229.0045 at 0047. 118 APRA.0229.0045 at 0046. 119

APRA.0229.0045 at 0045. 120 APRA.0229.0045 at 0047. 12 1

APRA.0251.0051 at 0052. 122 APRA.0229.0074 at 0074 to 0075. 123

CIV.017.119at144note13. 124 CIV.017.119at142note7. 125

APRA.0229.0074 at 0075 . 126 APRA.0229.0038. 127

APRA.0229.0040. 128 APRA.0053.0097 at 0103 . 129

APRA.0053.0097 at 0103. 130 APRA.0053 .0097 at 0102. 131

APRA.0053 .0097 at 0101. 132 APRA.0053.0097 at 0103. 133

APRA.0051.0002 at 0003. 134 APRA.0053 .0097 at 0129 and 0130. 135

CIV.017.152 at 160. 136 CIV.017.152 at 176 note 14. 137

CIV.017.152at174note7. 138 APRA.0053.0097 at 0130. 139

APRA.0053.0097. 140 APRA.0091.0001.

Th e failure ofHIH Insurance 39

14 1

APRA. 0053.0009 at 001 6. 142 APRA.0053 .0009 at 001 6. 143

APRA.00 53.0009 at 001 5. 144 APRA.0053.0009 at 0014. 145

APRA.0053.0009 at 0016. 146 APRA.0051 .0002. 147

APRA.0053 .0009 at 0040 to 0041. 148 CIV.005.21 6 at 226. 149

CIV. 005 .2 16 at 247 note 19 . 150 APRA.0053 .0009 at 0009. 151

APRA.0053 .0007. 152 Tll475/42 (Abela). 153 Tl1475/3 8 to Tl1475/59; T11476/39 to T11477/38 (Abela). 154

Tl1009/51. 155 T11010/41 to Tl1010/55 . 156

Tl1011 /19toT11011/22. 157 Tl1011 /36toT11011/41. 158

Tll012/3 toT11012/8. 159 Tl1475/38 to Tl1475/59. 160

Tl70 19/42 to Tl70 19/52 . 16 1 Tl7019/54 to Tl7019/56. 162

Tl7022/25 to Tl7022/30 . 163 Tl7022/37 to Tl7022/49 . 164

T17022/51 to Tl7022/58 . 165 Tl7023/2 to Tl7023/11 . 166

Tl702311 3 to Tl7023/15. 167 Tl7024/2 to Tl7024/9. 168

Ti 7205/40 to T17205/49 . 169 Tl7205/52 to Tl7206/4. 170

TI7206/49 to Tl7206/57. 17 1 Tl7207/43 to T17207/52 . 172

Tl7207 /52 to T17207 /54. 173 Tl7207/56 to Tl7207/59 . 174

Tl7208/1 4 to T17207 /15 . 175 T 17208/40 to T17208/41 . 176

Tl7209/9toT1720911 4. 177 Tl7209/45 to T17209/54 . 178

Tl7210/9 to Tl721 0/16.

40 Regulatory solvency

179

Tl7210/18 to T17210/29. 180 Tl7544/4 to Tl7544/14. 181

Tl7544/ 16 to Tl7544/21. 182 Tl7544/23 to Tl7544/29. 183

AARA.0464.0008. 184 Tl7545/13 to Tl7545/18. 185

SUBM.0027.001 at 012 par. 38 . 186 SUBP.0079.001 at 002 to 003 par. 7. 187

BKEM.0015.192. 188 SUBP.0044.001 at 003 par. 1(i). 189

BKEM.0015 .192. 190 SUBP.0044.001 at 009 par. 40. 191

SUBP.0007.001 at 036 par. 2.3 .3. 192 Tl1013/42 to Tl1013/5l. 193

Tl1015/46 to Tl1015/47. 194 Tll 013/53 to Tll 014118 ; Tl1 017/56 to Tl1 017/58 (Duesbury). 195

SUBP.0044.001 at 003 par. 1(j) . 196 T11015/15toT11015/42. 197

Tl1016110 to Tl1016117. 198 T11017/4toT11017/ 13 . 199

WITS.0162.001 at 062 par. 10.1.8. 200 SUBP.0044.001 at pars 004 to 005 pars 5 to 7. 20 1

Til 026/46 to Tll 026/50. 202 Tl1026/32 to Tll026/37. 203

Tl1 027/4 to Tl1 027/20. 204 Tll028/8 to T11028/12. 205

SUBM.0029.001 at 008 to 009 par. 24. 206 Tl1026/3 to Tl1027/2 (Duesbury). 207

SUBP.0044.001 at 007 pars 23 and 24. 208 Tl1 028/8. 209

Tll033/55 to Tll033/59. 210 SUBM.0029.001 at 013 par. 39.

Th e failure of H!H Insurance 41

20 The effect of incorrect accounting

I need to set out in some detail why I have undertaken the exercise that is set out in this chapter.

20.1 An accounting exercise

20.1.1 Actuarial reviews

Prior to the establishment of the Commission, the liquidator had commissioned a report upon the value of the claims reserves for the HIH group as at 15 March 2001. 1 The review was carried out by KPMG Actuaries Pty Limited and by Trowbridge Consulting. As summarised elsewhere, it expressed the opinion that the outstanding claims liabilities of the HIH group, if assessed net of reinsurance, after discount and as a central estimate without a prudential margin, totalled $5 billion. This was $1.9 billion in excess ofHIH's own assessment as at 31 December 2000.

Without discount and including a prudential margin of 25 per cent, the estimate of the HIH group's claims liabilities was $7.4 billion. The report of KPMG and Trowbridge was tendered in evidence before the Commission.

I decided that it would not be a fruitful use of resources- nor was it likely to be a productive exercise-for the Commission to engage more actuaries to carry out the same task. The work done by KPMG and by Trowbridge was accordingly not closely scrutinised during the hearings. In one respect (the allowance which it suggests ought to be made for liabilities purportedly assumed by HIH Re) I have formed a different view from the authors of the report. 2 Some criticisms have been expressed of the report at a relatively high level of generality, particularly by HIH's consulting actuary, David Slee.3 Nothing in those criticisms causes me to have any significant reservations about the utility of the phase II report. I have no reason to doubt its general reliability. In his December 2002 'high level' update of the phase II report, Wilkinson said that the reserve requirement remained within the range originally indicated, but his view of the best estimate had increased

significantly. 4

20.1.2 Possible insolvency

I can safely proceed on the basis that the general insurers in the HIH group were insolvent at 15 March 2001. They are being wound up in insolvency. As noted in Chapter 15, the liquidator has estimated a group deficiency of assets to liabilities of between $3.6 and $5.3 billion.

The failure of HIH Insurance 43

The discussion on which I am about to embark is not essentially about commercial insolvency in the sense of a company not being able to pay all of its debts as and when they become due and payable. Rather, the discussion which is to follow is aimed at assessing the combined effect of various accounting matters that have been the subject of findings here or elsewhere in the report.

The question whether, and if so for how long, before 15 March 2001 particular corporate entities which make up the HIH group were insolvent may, however, have general relevance essentially for two reasons. The first is that it may be relevant to the liquidator in civil proceedings for the recovery of property. That is not an issue with which I am concerned, although I recognise that the evidence produced before the Commission may be relevant to any such proceedings.

The second issue to which the question is relevant is in relation to the liability that di rectors of the companies that incurred debts might have for insolvent trading, if they had reasonable grounds for suspecting insolvency. 5 Again, the civil liability of the directors of the companies which incurred debts when the companies were insolvent is not of direct relevance to my inquiry. However, such directors, if they suspected insolvency, would have a criminal responsibility if they acted dishonestly

in failing to prevent a company from incurring such debts.

Counsel assisting did not submit that I should make an adverse finding that any person might have committed an offence under s. 588G of the Corporations Act. This was understandable, particularly having regard to the difficulty which any prosecution would face in establishing beyond reasonable doubt the insolvency of a general insurer with long-tail liabilities. Those difficulties were adverted to in a background paper prepared by those assisting me which was published on the Commission's website. 6 This is a matter to which I will return towards the end of this chapter.

The matter was further complicated by the way the group organised its affairs. The non-executive directors of HIH Insurance Limited were not directors of the licensed insurers. The businesses were administered on a portfolio-by-portfolio, rather than company-by-company basis, and administered by a separate subsidiary from the licensed insurers. For example, liability business was administered as a portfolio by HIH (Liability) Pty Limited and the portfolio comprised liabilities of HIH C&G, CIC, FAI General and CMG.

20.1.3 Under-provisioning

I did not attempt to have an actuarial valuation carried out to assess the outstanding claims liabilities of the HIH group at any date earlier than 15 March 2001, either using the data which the liquidator presently has, or from data as it existed at any earlier dates. I have however received and acted on evidence as to how additional information which emerged during the course of the Commission's hearings, or different assumptions, would be likely to have affected the valuations of liabilities carried out in the past. I have also considered in some detail in Chapters 14 and 15

44 Th e effect of incorrect accounting

the adequacy of the assessments made in 1998, 1999 and 2000 of the claims liabilities ofF AI and HIH. In so doing, I had regard to the material which was or should have been available to those making such assessments and, in the case of actuarial assessments, to the methodologies which the actuary used. In some cases this has enabled me to conclude that on the basis of information which was then available, or having regard to what I have identified as errors in methodology, provisions made for certain portfolios in both F AI and HIH were inadequate by at

least a certain amount. In this chapter I summarise some of the findings I have made in this regard in Chapters 14 and 15.

In many cases I have not been able to quantify the extent of under-provisioning. In some cases I have found that an actuarial opinion as to the value of liabilities was at the lowest end of a reasonable range.

In finding that adjustments of at least the amounts summarised in this chapter should have been made to the provision for claims liabilities, I have tried to avoid the use of hindsight. That is not to say that I suggest that any one individual had knowledge of all of the matters which give rise to the adjustments which I find should have been made at 30 June 1998, 30 June 1999 or 30 June 2000. I have brought a wider, if not a deeper, perspective to the issue of provisioning than any individual had at any of those dates. Thus, for example, it was not suggested that HIH's finance director, Dominic Fodera, knew the details of the methodologies which I have criticised and which were adopted by HIH's consulting actuary, Slee. Conversely, it was not suggested that Slee was responsible for making decisions as to what provision was booked in the company's accounts, nor that he was aware of deficiencies in data provided to him of which management was aware. In Chapters 14 and 15, I have addressed the question of what responsibility individuals had for the under-provisioning which I have found existed.

20.1.4 Reinsurance transactions

The Commission also examined closely four reinsurance transactions which are the subject of separate treatment in Chapters 14 and 16. In this chapter, I have summarised the adjustments to the financial statements which in my view ought to be made to reverse the wrong accounting for those contracts. Again, there is no element of hindsight if looked at from the perspective of the overall systems of corporate governance for HIH and F AI, including, management, directors, auditors and actuaries. However, in many cases the individuals involved in the accounting for the transactions could justly say that they were ignorant of matters upon which I rely as showing that the accounting was wrong. Again, I have addressed the responsibility of individuals in relation to these transactions in the relevant chapters.

Th e failure of HIH Insurance 45

20.1.5 Intangible and other assets

The Commission also considered the accounting for certain intangible and other assets, particularly future income tax benefits, deferred IT costs, deferred acquisition costs and goodwill in relation to HIH in 1999 and 2000.7 In this chapter, I summarise the results of correcting the accounting treatment which was adopted for some of those items in 1999 and 2000. In some cases I have not been able to quantify the full extent of the adjustment which should be made. For example, in the case of deferred acquisition costs I have found that no recoverability assessment was made when it should have been made but I am not able to say what the result of any such assessment would have been. Again, in summarising the adjustments which I think should be made to the accounts, I have tried not to use hindsight.

20.1.6 Goodwill

There is one qualification to this approach, and that is in relation to an adjustment to be made to goodwill at 30 June 1999. The effect of the corrections which should be made to the provision for F AI claims and to accounting for reinsurance contracts is that there would, on the fact of it, be a substantial increase in the goodwill booked at 30 June 1999, but only to the extent that its carrying value could be justified.

I have concluded that Andersen did not obtain sufficient appropriate audit evidence to substantiate the carrying value of goodwill arising in respect of the acquisition of FAI as at 30 June 1999 and which was booked at $275 million. For the reasons I give in Section 21.5 .7 in support of that conclusion, I think there is insufficient contemporaneous evidence to support any particular carrying value of goodwill arising from the F AI acquisition at that date.

On one view, I could say that as there were no reliable budgets upon which to make an assessment of future earnings, no amount should have been booked at 30 June 1999 for goodwill arising on acquisition of F AI. I have decided not to take that course, but in this instance, to use the benefit of hindsight by adopting the figure considered at 30 June 2000 to support the carrying value of goodwill attributable to the profitable lines of business which were transferred into the Allianz joint venture. I have found that no more than that amount of goodwill could justifiably have been carried at 30 June 2000 and I see no warrant for allowing additional goodwill arising from the F AI acquisition at 30 June 1999.

20.1.7 Going concern basis

The results of this summary are adjustments to the consolidated statement of net assets of HIH and its controlled entities as at 30 June 1999 and 30 June 2000. The adjustments, to my mind, are conservative partly for the reasons I have already given and partly because of the impact which the making of those adjustments would have had upon other items in the accounts. In particular, it seems to me that had appropriate provision been made at 30 June 1999 and at 30 June 2000 for the assets and liabilities I have considered in this chapter, the result would have been

46 The effect of incorrect accounting

that the going concern basis for preparation of the accounts would have been seriously in doubt. That consideration is reinforced by the fact that on a proper restatement of the returns required to be made by the licensed insurers to APRA, those licensed insurers, particularly HIH C&G, CIC and FAI, would have substantially breached the solvency tests under s. 29 of the Insurance Act 1973.

There would also have been breaches of financial covenants in various HIH loan agreements.

If the going concern basis could not be used for HIH's accounts it is likely that further downward adjustments would be required to the valuation of assets, such as deferred acquisition costs and deferred IT costs. The adjustments I have identified would require increases to be made to the provision for claims liabilities by reduction or estimation of the discount. Moreover, I would expect that, had the adjustments I have identified been made to the accounts at 30 June 1999, the market's reaction, and the reaction of the rating agencies, would have been such as to have affected profoundly the ability of the group to continue to trade.

20.1.8 Summary of approach

It is for these reasons that I said earlier that this chapter is not about insolvency of any of the companies in the HIH group in the technical sense of their ability to pay their debts when they fell due. Rather, it contains further findings in addition to those I have made elsewhere in the report. I have then assembled the findings made here and in other parts to the report which would lead to a correction of the consolidated balance sheet so as to demonstrate the overall effect of those adjustments.

2 0 .2 FAI-1 998

In Section 14.1.12, I have examined the shortfall in reserves ofF AI at 30 June 1998 in respect of the portfolios known as the Big Six, ALAS, MDU and Crane. I have there concluded that it is probable that, had PWC been provided with genuine case estimates in respect of these classes of business, there would have been a required increase in provision of about $190 million at that date. In Sections 14.4.1 0 and

14.4.11 I have concluded that, had the GCRA and NI contracts been properly accounted for at 30 June 1998, adjustments of $66.75 million would have been required to be made to the accounts ofF AI.

These adjustments would have had the effect of reducing the net assets of both F AI General and the consolidated net assets of F AI and its controlled entities and the shareholders ' equity attributable to members of F AI at 30 June 1998 , by about $255 million. Shareholders' equity in F AI and its controlled entities at 30 June 1998 was reported as amounting to $224.566 million.8 Had the adjustments been made which I think should have been made, the accounts would have shown that in fact

shareholders ' equity attributable to members of FAI was negative by some

The failure of HIH Insurance 47

$30 million. At 30 June 1998, FAI General's solvency margin for the purposes of the Insurance Act 1973, was, according to its lodged returns, only $26.357 million.9 If these adjustments had been made F AI General would have been substantially in breach of the conditions upon which it was authorised to carry on general insurance business.

In Section 14. 7.4 I consider the financial position ofF AI as at 31 December 1998. I will not repeat what I have there said. I have there made use of hindsight to express my opinion about the value of the liabilities ofF AI at that date and the value of its assets and business. In summary, far from having shareholders' equity attributable to members ofF AI Insurances Limited of $177 million or $157 million at 31 December 1998, I am of the view that, even after taking into account the value of the bu sinesses which were later transferred to th e Allianz joint venture, FAI' s shareholders' equity was negative by $291 million or $271 million.

20.3 HIH's consolidated balance sheet reconstruction as at 30 June 1999

The consolidated financial statement of30 June 1999 HIH reported 10:

20.3.1

FA/

Assets: Intangibles (goodwill) Future income tax benefits Other assets

Liabilities: Shareholders' equity Net tangible assets (classifying only goodwill as an intangible)

Liabilities

346.5 172.4 7 206.5 7 725.4 6 779.0

946.4

599.9

In Section 15 .8.3 I have found that $115 million of undiscounted claims liabilities were not provided for in the consolidated accounts to 30 June 1999, and that what was then identified to be a required provision of $10 million for doubtful reinsurance recoveries was not booked. The purported justification for not booking these exposures was the availability of recoveries under the GCR and Hannover contracts. As neither of those contracts should have been accounted for as reinsurance, but instead should have been accounted for as deposit arrangements, they provided no protection against a requirement to book the exposure. The evidence does not permit me to say what discount there should have been. Having regard to all of the adjustments which I consider should have been made to the accounts to 30 June 1999, I am of the view that in any event there would have been insufficient investments to support the group's liabilities. Hence, I do not consider that a further discounting adjustment is required.

48 The effect of incorrect accounting

Had the adjustments been made at 30 June 1999, questions would have arisen as to whether any future income tax benefits could have been recognised as an asset. As I am of the view that the requirements for recognising future income tax benefits were not met, I do not propose to allow for future income tax benefits.

This observation applies also to the further adjustments mentioned below. Had the adjustments been made at 30 June 1999, a further question would have arisen as to whether there should be a corresponding debit to goodwill. I propose to deal with the question of goodwill adjustments after considering all of the adjustments to liabilities.

In Section 15.5.4 I consider the provision made for the FAI corporate liability portfolio. For the reasons I there give I consider that portfolio was under-reserved by at least $30.7 million at 30 June 1999.

In Section 15.4.6 I consider the provision made for the FAI professional indemnity portfolio. The estimates of Slee and PWC were $6.9 million and $6.6 million greater than the provision booked at 30 June 1999, after appropriate adjustments are made for the MDU portfolio and overstated reinsurance recoveries. I am satisfied that the provision booked was inadequate to the extent of at least $6.5 million.

It was purportedly the practice of HIH to book the 'actuary' figure for CTP. However, in the case of FAI CTP, the figure booked at 30 June 1999 was $8.5 million below the reserve recommended by PWC for this portfolio. 11 Therefore, I consider the provision inadequate to the extent of $8.5 million.

In Section 15.4.6 I described issues which arose in 1999 and 2000 in relation to incorrect reinsurance recoveries generated by AEGIS, FAI's commutation of the 'FAI Re' arrangement with GCRA, problems with a 'systems fix' and disputed reinsurance recoveries. I there conclude that the allowance of $10 million which was identified in the course of the preparation of the 1999 accounts, but not provided for, was itself inadequate. Making use of some hindsight, I have concluded that an amount of between $67 million and $77 million should have been taken up as at 30 June 1999 rather than the $10 million dollar allowance which was identified.

Counsel assisting submitted that, on the state of the knowledge within HIH at the time of the finalisation of the 30 June 1999 accounts, a provision of about $30 million rather than $10 million should have been made. There was no precise basis for that submission. Nor could there be when the contemporaneous documentation identified that the provision to be made for the F AI Re commutation was not quantified. An attempt should have been made to quantifY the likely effect of that problem and to make provision for it. The IBNR allowance in respect of this

problem was still unquantified as at 30 June 2000. Given that it appears that the recoveries under the F AI reinsurance programme had been overstated by as much as $77.5 million, and that the relevant issues had all been identified, although not resolved, by 30 June 1999, I find it difficult to envisage how $10 million could be

an adequate provision.

The failure of HIH Insurance 49

Indeed, the information which was apparently not fully analysed until the next financial year was all available to management and in that sense the adjustments do not use the benefit of hindsight. Even apart from that consideration, there was an identified overstatement of reinsurance in respect of outstanding reinsurance recoveries of $16.7 million. 12 An additional $3 to $4 million provision for the other issues is the minimum I consider as acceptable. Accordingly, I am satisfied that at least an additional $20 million allowance should have been made against overstated

. .

remsurance recovenes.

These adjustments to the provisions made for claims liabilities in four areas of business and the additional provision for doubtful debts total $190.7 million.

HIHC&G In Section 15 .5.4 I have concluded that Slee's valuation of the liability portfolio at 30 June 1999 was at least $106.2 million too low. The provision which was booked for this portfolio at 30 June 1999 was $33.4 million below Slee's valuation. 13 However, the schedule of reserves also disclosed that there was a 'head office adjustment' of $7.8 million by way of a negative reserve for the liability portfolio. 14 There was no proper basis for this adjustment. A 'debit claims reserve' was created as at 31 December 1998. Part of the purported profit booked under the Hannover transaction was used to reverse part of this 'reserve' .15 The creation of a 'debit claims reserve' was simply a way of reducing a provision and thereby increasing reported profit in the period. By its accounting for the Hannover transaction, HIH substituted one illegitimate profit for another. By 30 June 1999 there remained, however, a debit claims reserve of $7.8 million for the liability portfolio. 16 There was no appropriate basis for reducing the provision for the liability portfolio further. Accordingly, I am satisfied that the liability provision was inadequate by at least $147.4 million.

In Section 15.7 I have concluded that Slee's estimate for the HIH C&G workers compensation portfolio at 30 June 1999 was at the minimum reasonable level. The provision that was booked for this portfolio was $5.4 million below Slee's estimqte. 17 I am satisfied that the provision was inadequate by at least that amount.

In Section 15.9.4 I have referred to the purported allocation of a head office reserve of £4 million or about $11 million to the UK branch to bring the branch reserves up to the minimum required by Andersen (UK). It would follow that there was an unallocated shortfall of reserves elsewhere in the group of $11 million. I consider that an additional $11 million provision ought to have been made by HIH C&G in respect of the liabilities of the UK branch without any reduction of reserves elsewhere in the group. I therefore conclude that in respect of the UK branch there was an inadequate provision of at least $11 million.

With the benefit of hindsight, or even arguably without the benefit of hindsight, it can be seen readily that the UK branch was under-reserved by a vastly greater amount. However, for the purposes of this exercise I am accepting that HIH could properly have made provision for the claims liabilities of the UK branch at the

50 Th e effect of incorrect accounting

minimum insisted upon by its UK auditors. That is a benevolent approach. Insurers should not reserve at the minimum possible level. However, for the purposes of this exercise I am concerned to identify what would be the likely consequences of making what I regard as the minimum necessary adjustments to the group's reserves.

These adjustments to the provision for claims liabilities of HIH C&G total $163.8 million.

CMG

In Section 15.5.4 I conclude that there was no proper basis for the reduction in the claims liabilities of the CMG liability portfolio at 30 June 1999 of $21.3 million and that the draft valuation of $4 7 million was more likely to represent a central estimate of the portfolio. HIH booked $5.8 million more than Slee's final valuation 18, but I believe the provision was still inadequate by about $15 million.

HIH America In this chapter I am concerned with the booked provision at group level for HIH America rather than the provision booked in HIH America itself. In Section 15.10.2 I have concluded that at 30 June 1999 the provision in the consolidated accounts of HIH and its subsidiaries in respect of HIH America, was inadequate by at least $13 million.

Summary of adjustment to claims provisions These are what I consider to be the minimum adjustments which should have been made to the provisions for claims liabilities at 30 June 1999. The total value of the adjustments which I have identified is $382.5 million made up as follows:

• FAI- $190.7 million, including $30 million provision for doubtful reinsurance recoveries

• HIH C&G-$163.8 million

• CMG- $15 million

• HIH America- $13 million.

Some of the reserves increased are net of reinsurance and some had no reinsurance. The increase to the group's reserves, gross of reinsurance would be greater than the $382.5 million I have identified. Increasing gross reserves by only $382.5 million would take them to $4082 million at 30 June 1999.

Future claims handling costs In Section 15.4.1 I have concluded that HIH did not make an appropriate allowance for its future claims handling costs because no analysis was carried out as to what were the actual costs of the handling of claims. In the absence of that analysis, I have concluded that an appropriate allowance was 5 per cent. The amount booked by the company for future claims handling costs as at 30 June 1999 was

Th e failure ofHIH Insurance 51

approximately 1.49 per cent of its gross outstanding claims liabilities. 19 On that basis an additional provision of 3.5 per cent of $4083 million should be made. Counsel assisting submitted that the appropriate adjustment was 3 per cent and I am prepared to act upon that submission. The result is that an additional $122 million ought to have been provided for to make an appropriate allowance for future claims handling costs.

Liability for converting notes

In Section 14.6.8 I have concluded that HIH, having assumed the investment risk in respect of the notes subject to the total return swap agreement, should have booked as a liability at least $35 million. It stood to lose that deposit and it ultimately did so. Accordingly, the financial statements of the consolidated entity should be adjusted

by reducing equity and increasing liabilities by $35 million.

20.3.2 Assets

Reinsurance recoveries In Section 16.9 I have concluded that at 30 June 1999 the GCRA XOL contract should have been accounted for as a deposit transaction with a consequent of the consolidated entity of reduction of the tangible assets of $29.273 million, excluding any future income tax benefit or consequential adjustment to goodwill.

In Section 16.9 I have concluded that a similar adjustment should be made in respect of the National Indemnity contract in the amount of $33.808 million.

In Section 16.2.7 I have concluded that the profit of $92.350 million booked at 30 June 1999 under the Hannover transaction was improperly booked. There should be a consequential adjustment. Again, I make these adjustments without an offsetting amount for future income tax benefit or consequential adjustments to goodwill.

The incorrect reinsurance recoveries under the GCRA and NI contracts were booked to F AI General. In relation to Hannover, the profit of $92.350 million was split between HIH C&G ($56.4 million), F AI General ($24. 7 million) and the group by applying the discount adjustment to goodwill ($11.3 million). 20

HSI As at 30 June 1999 F AI held an investment in HSI of 2 150 000 shares. Those shares were valued in the financial statements at $28 584 378, on the basis of a 'third party' offer price (from Cooper) ofUS$8.80. The market price of the shares at the time, however, was US$5.63, being some $10.3 million below the value recognised in the financial statements.

Andersen proposed an adjustment to the carrying value of this asset of $10 million. 21 However, the audit committee accepted management's valuation of the asset which was based upon a letter of offer dated 12 January 1999 from Cooper to Adler. 22 That offer was no longer current when the 1999 financial statements

52 The effect of incorrect accounting

were prepared. It came from a person who was the chairman and chief executive of HSI and could not have been taken as a market price which another willing buyer may have paid. I am satisfied that it was quite inappropriate to value the shares in HSI at the price Cooper had offered in January. Andersen's proposed adjustment to this value should have been made, but was not. I find that the shares in HSI were over-valued in the financial statements as at 30 June 1999 by at least $10 million?3

Future income tax benefits

In the consolidated financial statements as at 30 June 1999, HIH recorded as an asset future income tax benefits attributable to tax losses of $27.2 million and future income tax benefits attributable to timing differences of $145.2 million. 24

The tax losses asset of $27.2 million was arrived at after setting off a provision for deferred income tax of $113.6 million. That is, before the set off, the group had tax losses of $140.8 million of which $113.6 million was applied as a provision for deferred income tax.

The asset of $145.2 million for future income tax benefits attributable to timing differences was also a net figure which was arrived at after setting off $60 million as a provision for income tax.

I deal with the accounting for these assets in Section 21.5.4. Having regard to the unreliability of the budgets, the uncertainty attending the provisions, and the fact that HIH C&G, F AI General and CIC were in contravention of the conditions upon which they were authorised to carry on insurance business, it could not be said, as at 30 June 1999, that the future income tax benefits were assured beyond reasonable doubt or were virtually certain. Accordingly, the future income tax benefits should have been written down by at least $172.4 million.

Counsel assisting also submitted that there was no evidence to support the set-off of $81.5 million of the $113.6 million which was applied towards the liability for deferred income tax. Nor, counsel submitted, was there evidence to support the application of $60 million of future income tax benefits due to timing differences against the provision for income tax. Accordingly, counsel assisting submitted that an additional adjustment of$141.5 million should be made.

In Section 21.5.4 I have found that the audit evidence obtained by Andersen suggested a prima facie breach of AASB 1020 by the offset of the provision for deferred income tax against future income tax benefits attributable to tax losses and that Andersen did not obtain sufficient appropriate audit evidence to justify that offset. I made no findings in respect of the offset of provision for tax against future

income tax benefits attributable to timing differences in light of submissions made by Abela and Andersen. I am not able to determine, particularly in light of submissions made by Abela, the extent to which each of the offsets was wrong.

For present purposes the only adjustment which I make to the future income tax benefits is a reduction in the asset booked of $172.4 million .

Th e failure ofHIH Insurance 53

20.3.3 Summary of adjustments at 30 June 1999

Table 20.1 summarises the adjustments at 30 June 1999.

Table 20.1 Summary of adjustments, 30 June 1999

Adjustment

FAI problem claims and provision for doubtful debts

FAI corporate liability

FAI professional indemnity

FAI compulsory third party

Further FAI provision for doubtful reinsurance recoveries

C&G liability

C&G workers compensation

UK branch

CMG

HIH America

FCHC

Converting notes

GCR/NI

Hannover

HSI

FITB

Total

$m

125

31

7

8

20

147

6

11

15

13

122

35

63

92

10

172

877

As I have already mentioned, on the face of it, there could be an upwards adjustment to goodwill in respect of the increase in the provision for F AI claims (almost all of which were incurred before 31 December), and the reversal of net reinsurance recovenes.

However, $275 million was already recognised as goodwill on the acquisition of F AI. For the reason already mentioned, I think I should adjust the goodwill at 30 June 1999 to reflect the $321 million of goodwill recognised at 30 June 2000 following the agreement to transfer the profitable lines of business to the Allianz joint venture. Accordingly, I think the provision for goodwill should be increased

from $275 million to $337 million, an increase of$62 million.

These adjustments would result in a reduction of net assets of $815 million.

The group reported net assets of $946.4 million. The adjustments I have summarised would result in a substantial deficiency of net tangible assets. In arriving at the revised net assets of $131 million, it must be borne in mind that about $400 million of the gross assets represents goodwill.

54 The effect of incorrect accoun ting

20.3.4 Solvency margins at 30 June 1999

According to its 30 June 1999 APRA return, HIH C&G had a margm of $169 .711 million over its minimum solvency requirement. 25

F AI General had a margin of $48 .643 million over the minimum solvency requirement for assets and liabilities in Australia and $90.93 1 million for assets and liabilities in total. 26

CIC had a margin of$17.139 million over the minimum solvency requirement. 27

The adjustments set out above which relate specifically to HIH C&G total $22 1.2 million, not including its proportion of the increased provision for future claims handling costs or any adjustment for future income tax benefits due to timing differences?8 I therefore conclude that HIH C&G was in breach of the minimum solvency conditions on which it was licensed to carry on business.

The adjustments set out above which relate specifically to F AI General total $278.5 million, not including its proportion of the increased provision for future claims handling costs or any adjustment for future income tax benefits due to timing differences.29 I therefore conclude that it too was in substantial breach of the minimum solvency conditions imposed by the Insurance Act 1973.

I have found in Chapter 19 that CIC, by reason of its having charged financial instruments owned by it with a face value of $154 million, was also in breach of those conditions at 30 June 1999.

20.3.5 Breach of loan covenants

Although the terms of HIH's loan facilities were not the subject of detailed consideration, it seems likely that these adjustments would have led to there being events of default on a number of facilities. For example, Minter Ellison summarised the terms of a US$66 million note issue as including that HIH C&G at all times maintain a 50 per cent margin over the Insurance Act solvency requirements.

30 On

default the debt could be declared due and payable without further notice.

Under a US$75 million facility provided to FAI, FAI was required to have group shareholders' funds of not less than $200 million. 31

A consolidated balance sheet of F AI prepared as at 30 June 1999 showed that shareholders' equity attributable to members had fallen to $77.404 million at 30 June 1999. 32 That included $162.556 million of future income tax benefits. 33

If

the adjustments I consider should have been made were made, there would have been a deficiency of assets to liabilities of $363.6 million.

I am satisfied that had the adjustments been made there would have been substantial breaches of HIH' s loan facilities.

The failure ofHIH Insurance 55

20.3.6 Going concern basis

Had these matters been taken into account, as I think they should have been at 30 June 1999, there would have been at least a serious doubt as to whether the group accounts could properly have been prepared on the basis that the group would continue as a going concern. This may have led to a further write-downs in the group's deferred acquisition and information technology costs. The adjustments would have required a substantial increase to the claims provisions to reduce or eliminate the discount applied.

I believe that if the adjustments I have identified had been made, as I believe they should have been, the group's ability to continue to trade after August 1999 would have been doubtful.

20.4 Adjustments to the consolidated balance sheet of HIH and subsidiaries at 30 June 2000

In the consolidated financial statements of 30 June 2000, HUT reported34 :

20.4.1

Assets: Intangibles (goodwill $475 .3 million and management rights $19 .1 million) Future income tax benefits Other assets

Liabilities: Shareholders' equity Net tangible assets

Liabilities

Claims provisions

494.4 228.4 7 604.3 8327.1 7 388.0

939.1 444. 7

In Section 15.5.4 I have found that Slee's valuation of the HIH C&G liability portfolio at 30 June 2000 was too low by $43.3 million. The amount booked by HIH in respect of this portfolio was $229 million compared to Slee's valuation of $270.3 million. Accordingly, I am of the view that the provision was inadequate to the extent of $84.6 million. In that same section I have observed that management of HIH Liability Pty Ltd itself regarded the portfolio as being under-reserved at 30 June 2000 by $58 million. ·

In Section 15.6.3 I have found that Slee's valuation of the HIH C&G professional indemnity portfolio was too low by at least $65 million. I was unable to quantify the extent to which his valuation of the large claims exposure was inadequate. HIH booked a reserve $6 million higher than Slee's valuation. In my view, the amount booked was still inadequate to the extent of $59 million. In addition, Wilkinson's estimate as at December 2001 was that the gross undiscounted value of the builder's

56 Th e effect of incorrect accounting

warranty business excluded from Slee's valuation was about $20 million for each of HIH C&G and F AI. 35

In Section 15.7 I have found that Slee' s valuation of the workers compensation portfolio was at the lowest reasonable level. The reserve booked was $2.8 million below Slee's estimate and I there expressed the view that the provision made was inadequate to that extent.

In Section 15.8.4 I have concluded that the provision made for HIH C&G's US liability claims was inadequate to the extent of $25 million.

In Section 15.4.6 I have found that the provision made at 30 June 2000 for doubtful reinsurance recoveries by F AI was under-stated by at least $18.6 million.

The total of these adjustments is $191.4 million for HIH C&G and $38.6 million for FAI.

In Section 15.9.6 I have found that Slee's valuation of Cotesworth liabilities was understated by at least $10 million. However, I make no adjustment for that because the total provision booked at 30 June 2000 for the UK Branch and Cotesworth combined was $1.9 million in excess ofthe actuary's valuation. 36

In the case ofHIH America I have found in Section 15.10.3 that HIH America was under-reserved by US$55 million at 30 June 2000 and the group was under-reserved by A$72 million.

The sum of these adjustments for the group is $302 million. The adjustments would have the effect of increasing the gross undiscounted reserves by substantially more than that amount. Recorded gross claims liabilities before the adjustment were $4430 million. The total adjusted gross liabilities are $4732 million. As for 1999, I believe that a further adjustment of 3 per cent to those gross liabilities should be made as an appropriate allowance for future claims handling costs. This is an amount of $142 million.

Thus I am of the view that, having regard only to the adjustments which I have identified, the financial statements at 30 June 2000 made an inadequate provision for claims liabilities of at least $444 million.

Converting note issue For the reasons already stated the converting note issue, to the extent it was subject to the total return swap agreement, should have been accounted for as a liability at 30 June 2000 and not as equity. This requires an additional $35 million adjustment.

The failure of HIH Insurance 57

20.4.2 Assets

Reinsurance recoveries For the reasons in Section 16.13, I consider that adjustments ought to have been made to the consolidated accounts at 30 June 2000 properly to account for the GCRA aggregate excess of loss contract and the NI reinsurance contract by $2.5 million37 and $25.6 million respectively.38

In Section 16.2.13 I have found that both Hannover 1 and Hannover 2 reinsurance contracts were improperly accounted for as at 30 June 2000. The effect of accounting for those contracts as a deposit arrangements at 30 June 2000 is to require a downward adjustment to . net assets of $143.6 million in respect of Hannover 1 and $48.4 million in respect of Hannover 2 (again excluding any adjustment to the future income tax benefit).39

In Section 16.3 I have found that the Swiss Re reinsurance contract should have been accounted for by expensing the amount of premium that was required to fund the reinsurance recovery which was booked together with the fee payable to Swiss Re insofar as it related to that recovery. The consequence is that I consider an adjustment of more than that which was proposed by counsel assisting should be made. In my view, the adjustment should be a reduction in net assets of $131 million ($220 million recovery funded by premiums of $220 million plus Swiss Re's 5 per cent fee amounting to about $11 million, less the $100 million recognised at 30 June 2000). Again, I exclude from this adjustment any adjustment to the future income tax benefit.

The reinsurance adjustments total $3 51.1 million.

Deferred IT costs In Section 21.5.6 I have considered the deferred IT costs which Andersen identified as not being of a kind which could properly be capitalised. These amounted to at least $8.6 million. These I consider ought to have been accounted for as operating costs of the period in which they were incurred and so an adjustment of $8.6 million is required to the consolidated accounts .

Future income tax benefits In the consolidated financial statements to 30 June 2000 HIH recognised as assets future income tax benefits attributable to timing differences totalling $91.2 million and future income tax benefits attributable to tax losses totalling $137.2 million40, a total of $228.4 million. As in 1999 these were net figures. A provision for deferred income tax of $131.3 million was offset against the future income tax benefits relating to tax losses. A provision for income tax totalling $96.7 million was offset against future income tax benefits relating to tax losses and timing differences. 41

In Section 21.5 .4 I have found that the audit evidence obtained by Andersen suggested a prima facie breach of AASB 1020 by the offset of the provision for deferred income tax against future income tax benefits attributable to tax losses and

58 The effect of incorrect accounting

that Andersen did not obtain sufficient appropriate audit evidence to justify that offset. I made no findings in respect of the offset of provision for tax against future income tax benefits attributable to timing differences in light of submissions made by Abela and Andersen. I am not able to determine, particularly in light of submissions by Abela, the extent to which each of the offsets was wrong.

Leaving aside the question of set-off, I am satisfied that no amount should have been booked for future income tax benefits at 30 June 2000. It was not virtually certain or beyond reasonable doubt that HIH would realise those benefits. Each of HIH C&G, CIC and FAI General was in breach of the conditions upon which it was authorised to carry on business under the Insurance Act. 42 Loan covenants had been breached. The reported profits in 1999 and 2000 depended upon incorrect accounting for the whole of account reinsurance contracts I have considered. Forecast profits were based on unreliable budgets. Further, as the group was purportedly reserving to a central estimate, there remained a substantial risk, which of course eventuated, that the provisions for outstanding claims would be inadequate.

Accordingly, an adjustment of $228.4 million should be made to the consolidated statement of net assets.

Goodwill In Section 21.5.7 I have concluded that Andersen did not obtain sufficient appropriate audit evidence as to the carrying value of the residual goodwill, that is, the goodwill attributable to the F AI acquisition which remained after taking into account the lines of business transferred to the Allianz joint venture. This totalled $84 .3 million plus the goodwill booked at 30 June 2000 in relation to HIH America and which was said to be supportable as additional goodwill arising from the acquisition ofFAl ($23.9 million).

I am satisfied that both the $23 .9 million attributable to US goodwill, and the $84.3 million of goodwill attributable to the lines of business not transferred to Allianz should have been written-off at 30 June 2000. As explained in Section 21.5 . 7, there were no reliable budgets upon which to make assessments of future earnings. The projections of future earnings were based either on reported previous actual earnings or budgeted earnings depending upon which was higher, and the divisions in question in fact contributed a substantial loss to the core earnings in the six months to 31 December 2000 just as they had in the previous

12 months. In my view, therefore, there should be an adjustment of $108.2 million to the amount of goodwill recognised in the consolidated financial statements to 30 June 2000.

Th e failure of HIH Insurance 59

20.4.3 Summary of adjustments

Table 20.2 summarises the adjustments at 30 June 2000.

Table 20.2 Summary of adjustments, 30 June 2000

Adjustment

C&G liability

C&G professional indemnity

C&G builders warranty

FAI builders warranty

Workers compensation

C&G US liability

FAI reinsurance recoveries

HIH America

FCHC

Converting notes

GCR

Nl

Hannover

Swiss Re

Deferred IT

FITS

Goodwill

Total

$m 84.6

59.0 20 .0

20 .0

2.8

25.0 18.6 72.0 142.0

35.0 2.5 25.6 192.0 131.0

8.6

228.4 108.2 1175.3

The group reported net assets and total shareholders' equity at that date of $939.1 million. As I have said, I regard these adjustments as conservative and the minimum adjustments which are required to be made, particularly in relation to the provision for outstanding claims liabilities. Even so, these adjustments indicate a

deficiency of shareholders' equity of more than $200 million at 30 June 2000.

That in itself, together with the continued contraventions of s. 29 of the Insurance Act 1973, and continued defaults on the loan covenants, would have meant that the going concern basis of account preparation was seriously in doubt. As for 1999, this may well have led to a revision of the value placed upon such assets as deferred technology costs and deferred acquisition costs. The adjustments should have led to an increase in the provision for claims liabilities due to a reduction in the discount as there would be insufficient investments to satisfY all of the group's liabilities.

By the time the 30 June 2000 accounts were finalised, the group had already commenced the process of selling off restructured parts and restructuring the remainder of its business.

60 The effect of incorrect accounting

20.5 Insolvent t ra ding

Repeating the cautionary note that this chapter is not essentially about commercial solvency, I wish now to return to the subject of insolvent trading. I do so because I realise that some members of the public may assume that with a deficiency the size that the HIH shortfall appears to be there must necessarily have been insolvent trading.

Each of the directors of HIH was subject to the insolvent trading provisions of the Corporations Law. As I said earlier, under s. 588G of the Law a civil liability and a civil penalty liability can be imposed on directors of companies that incur debts while the company is insolvent. In certain circumstances, criminal liability can also be imposed. Such liabilities can only arise after the company is in liquidation.

The essential element which must necessarily be established in proceedings alleging insolvent trading under s. 588G ofthe Law is that:

• the company is insolvent at the time it incurs the debt, or becomes insolvent by incurring that debt, or by incurring at that time debts including that debt

• at that time, there are reasonable grounds for suspecting that the company is insolvent, or would so become insolvent, as the case may be.

The first question in any consideration of HIH directors' liability for insolvent trading is whether the company was insolvent at the time that liability under s. 588G is sought to be imposed. Insolvency must be assessed according to the definition in s. 95A of the Act, namely that the company is unable to pay all its debts as and when they become due and payable. 'Commercial insolvency' is different from the question whether, as an authorised entity, the company met the solvency ratios under the Insurance Act 1973.

The assessment of the commercial insolvency of an insurance company under the Corporations Law can be complex and difficult for reasons that include the uncertain nature of an insurer's liabilities. These liabilities may relate to future events and be subject to contingencies, including the outcome of future litigation. Nonetheless, they are booked as liabilities. The notion or concept of insolvency

under the Corporations Law and its application to general insurers is discussed in detail in the Commission's Background Paper no. 14 'The assessment of the insolvency of a general insurer'. I do not propose to repeat what is there written.

In the case ofHIH, and in light of these difficulties, I have made no definite findings as to a particular date or dates prior to 15 March 2001 at which HIH became insolvent. It will be clear from the discussion in this chapter that, in my view, the state of HIH's shareholder funds at 30 June 1999 was parlous and that there was a deficiency of shareholders funds as at 30 June 2000. I am not able to conclude whether that translates to commercial insolvency for a particular company at any particular date.

The failure of HIH Insurance 61

Even if a finding of commercial insolvency of HIH at a particular date could confidently be made, a director would only be liable for insolvent trading if, at the date in question, the director had reasonable grounds to suspect insolvency in terms required by s. 588G(l)(c). The reverse proposition, namely that the director had reasonable grounds to expect (and did expect) that the company was solvent, may be advanced by the director as a defence in proceedings by virtue of s. 588H(2).

In deciding whether a director had engaged in insolvent trading, the first step would be to identify the corporate entity that incurred the debt or debts in question. That entity is very likely to be a subsidiary rather than the holding company. It would then be necessary to identify the directors of the entity concerned. In the HIH structure many of the subsidiaries had on their boards a combination of some holding company directors and some members of management. It would then be necessary to decide whether that subsidiary was insolvent. If the debt was incurred by a subsidiary whose solvency (as a stand alone entity) was suspect, the directors would very likely claim that they relied on, and were entitled to rely on, support from other companies in the group. This, in tum, would necessitate an examination of the state of knowledge of each director of that subsidiary as to the financial state of the group. That state of knowledge would then determine the reasonableness of the reliance the director placed on the likelihood of support from other members of the group.

A director of a subsidiary who was also a director of the holding company would have the knowledge of the financial state of the group that he had gained in the latter capacity. A director of the holding company who was not formally a director of the subsidiary might nonetheless be deemed to be a director through what is sometimes called the 'shadow director' extension of the definition of 'director' in s. 9 of the Corporations Law. But in a complex group structure like HIH that would not be easy to establish. The state of knowledge of a director of a subsidiary would fall to be determined in the manner I described in the previous paragraph.

I think the difficulties to which I have referred explain why counsel assisting did not contend that any director might have contravened s. 588G. In the absence of evidence about specific debts incurred by specific entities and without evidence of the state of knowledge of the directors of the entity concerned, no such finding could be made.

These difficulties became apparent at an early stage in the inquiry and it therefore was not a focus of attention. With that in mind, little evidence was led that would enable any meaningful consideration to be given to the question of whether any particular directors had, at particular dates, reasonable grounds to suspect the insolvency of any particular companies. As appears from Chapter 17, the preponderance of evidence (so far as it went) is that this matter did not come to a head until 14 March 2001. There was then no delay in the directors taking action to have the company placed in provisional liquidation. They did so on 15 March 200 I. .

62 The effect of incorrect accounting

CORE.0009A.295.

See Chapter 15 .9.2.

WITS .0118.001 at 084 to 088 pars 320 to 341.

WITS.0296.00 1 at 002 par. 4.

Corporations Acts. 588G (1) .

CORE.054.001.

See Chapter 21.4.

CIV.019.091 at 125 .

APRA.0205.0300 at 0301. 1 ° CIV.001.838 at 876 and 893. 11

SBB.020.367 _001; PWCA.0011.001 at 005 and 019; AND.l397.0001.0229; Tl3158/ 12 to Tl3159/41 (Fodera). 12

13

14

IS

SUBM.0013.001 at 196 to 197 pars 794 to 800.

SBB .020.367 001.

SBB.020 .367 001 at 367 003. - -AA.0009.0003.0184 at 0186; AARC.0015.001 at 002. 16 For the creation of this negative reserve in December 1998 and its reduction in June

1999 see BKEM.0019.090 at 100. 17 SBB.020.367 001. 18

SBB.020.367 001. 19 CIV.001.838 at 894. 20

See Section 16 .2.8. 21

22

23

AARC.0002.033 .

SBA.214.140 001.

AARC.0002.033; SBA.214.140_001. 24 WITS.0249.001 at 017 . 25

DETT.0005.007; AP.0002.0010.0130. 26 DETT.0002.016; DETT.0002.018. 27

DETT.0005.003. 28 $165.2 million increased provision for claims liabilities and write back of $56.4 million profit under Hannover. 29

$109.7 million increased provision for claims and write backs of $29 .3 million, $33.8 million and $24.7 million under the GCRA, NI and Hannover contracts. 30 DEUB.0001.644 at 649 to 650. 31

DEUB.0001.644 at 653 to 654; AND.1063.0001.1324 at cl. 7.5 of schedule 5, part 2 and WPAC.0002.005, cl. 8.4 of annexure 1. 32 AARA.0214.0015. 33

AARA.0214.0017 at 0019. 34 CIV.001.926 at 952 and 972.

The failure of HIH Insurance 63

35

36

37

38

39

40

41

42

64

WITS.0003.001 at 018 par. 40.

SBB.020.367 _001 at _002; SUBM.0022.001 at 026 .

WITS.0028.001 at 032; SUBM.0022.001 at 026.

WITS.0028.001 at 047 to 048 ; SUBM.0022.001 at 027 .

WITS.0028.001 at 063 and 074 to 075.

CIV.001 .926 at 972.

The evidence is summarised at SUBM.0022.00 1 at 031 .

HIH C&G reported a solvency surplus of$214.287 million. (DETT.0005 .007) . The adjustments for claims provisions and over-stated reinsurance recoveries far exceed this reported surplus. CIC reported a solvency surplus of $46.3 million. (DETT.0005 .003). This included charged assets of$159.5 million. (APRA.0053 .0097 at 0105). FAI General reported a solvency surplus of$62.716 million. (DETT.0002.018). The net profits under the four reinsurance contracts booked to F AI at 30 June 2000 substantially exceeded this reported surplus. (WITS.0009.001 at 005 to 007; WITS.0024.001). FAI General also had included assets charged to $36.9 million in its return. (APRA.0053.0179 at 0188).

The effect of incorrect accounting

21 The audit function

The terms of reference directed me to inquire into the question whether, and if so the extent to which, decisions or actions of any of the auditors of HIH contributed to its failure or involved or contributed to undesirable corporate governance practices, including any failure to make desirable disclosures regarding the financial position of HIH. Pursuant to that instruction, in this chapter I consider certain aspects of the HIH audit and the actions of its auditors, Andersen, in the context of the failure of HIH.

21.1 Approach to this chapter

I have examined the audit process and Andersen' s approach to it, including the relationships between Andersen and the board and management of HIH. I address in particular a number of issues dealt with by Andersen in the course of its 1999 and 2000 audits, namely accounting for future income tax benefits, deferred acquisition costs, deferred information technology costs and goodwill. Andersen' s audit work in respect of the going concern basis of the 1999 and 2000 audits is then considered. The going concern assessment is a key indicator of the financial strength or weakness of a corporation and is a fundamental factor in audit approach and

methodology.

Andersen's audit work and involvement in reinsurance, provlSloning, pledged assets, netting-off and other matters affecting F AI and HIH are discussed elsewhere in this report.

Auditors play a vital role in the financial reporting process. This is particularly so in relation to companies such as HIH, the true financial position and performance of which is a matter of national economic significance. A properly conducted audit should enable users of the financial report of the company (including regulators,

shareholders, policyholders, lenders and other creditors) to rely upon the accounts with a degree of confidence. The audit process should be designed to provide the company and users of its accounts with early notice of potential risks affecting the company's short- or long-term viability.

It is sometimes suggested that whenever a company fails its auditor must have been at fault. I do not subscribe to that theory. The work performed by the auditor must be carefully analysed, having regard to all of the circumstances of the audit process, to determine whether the audit work was deficient and, if so, whether that deficiency contributed to the collapse of the company. In the present context, consideration of Andersen's independence and audit methodology is as important as a technical analysis of its audit work. The former sheds light upon the circumstances in which

The failure ofH!H Insurance 65

the audits were conducted and thereby illuminates the auditors' approach to the technical issues which they confronted.

This chapter should be read in conjunction with other sections of the report. In particular Chapter 20 of the report dealing with reconstruction of the HIH balance sheet incorporates my findings about the quantified effect of specific accounting issues on the balance sheet ofHIH.

21.2 Procedural fairness

Andersen raised several concerns about the procedural fairness afforded to it in the conduct of the inquiry. Most of those concerns related to individual issues, for example that a particular matter was not put to a witness. Those particular concerns are addressed in the context in which they arose in this chapter. Some of Andersen's concerns were more general. It is appropriate to consider them here.

Andersen made submissions in relation to Practice Note 6, introductory and general matters, and procedural fairness. They are dealt with below. In summary, I consider that Andersen was accorded procedural fairness in the conduct of the Commission's mqmry.

21.2.1 Breach of law

Andersen submitted that paragraph (b) of the terms of reference did not encompass a breach of, for example, an equitable or common law duty that would do no more than enliven the civil jurisdiction of the courts. I accept that submission. I have set out my views on that issue in Chapter 1.

Andersen also submitted that I should not make findings the effect of which would be to conclude that there had been a breach of such a duty. I also accept that submission. However, this does not extend to findings, for example, that Andersen 'failed' to comply with a relevant audit or accounting standard. 1 Mere failure to comply with such a standard does not of itself amount to a breach of any legal duty. No finding that I have made carries with it a conclusion that Andersen was liable in that sense.

Any finding that I have made is, of course, based only upon the evidence before me. It is quite possible that further material may come to light after this report is delivered. Whether or not such evidence affects any finding I have made will be a matter for others to determine.

21.2.2 Corporate governance

Andersen submitted that the term 'corporate governance' does not include the scope or quality of Andersen's audit work and should be limited to such matters as Andersen's appointment, the procedures for communication between Andersen and

66 The audit function

the HIH board and the activities of the HIH audit committee. I do not agree. I have addressed these matters in Chapter 1.

21.2.3 Limitations of the Commission proceedings

Andersen submitted that I should consider the following matters when assessing the totality of the evidence before me. With the exception of the third and fourth matters, I consider them relevant and I have taken them into account in my assessment of the evidence.

• The fact that some issues were the subject of evidence from only some of the persons who would or could give probative evidence dealing with that issue.

• The fact that certain propositions of fact, conclusions or other suggestions were put to only some of the persons who could properly be asked to comment on such suggestions.

• The fact that, although the 'parties' to the Commission were entitled to apply for leave to cross-examine witnesses, often the evidence of witnesses was not tested by the representatives of parties advancing materially different evidence.

• The fact that a register of attendance of parties before the Commission on any particular day or at any particular time was not kept.

• The fact that the rules of procedural fairness require that findings of fact upon which my decisions are based must be supported by probative evidence and any inferences of fact upon which decisions are based must reasonably be able to be drawn from such findings of fact.

I have addressed these matters in the context of dealing with specific issues where necessary.

Andersen also submitted that its ability to deal with issues raised in the course of the inquiry was subject to limitations of time and associated problems of access to documents. It submitted, and I agree, that the process by which documents were obtained by the Commission was not comparable to discovery in civil litigation. Similarly, however, my report is not comparable to a judgment resolving civil litigation. Andersen had relatively more time to prepare evidence and materials than many other parties because the audit phase of oral hearings was in the latter part of the inquiry. Accordingly, whilst I have taken the limitations raised by Andersen into account in my consideration of the evidence, I think the manner in which the Commission conducted its proceedings was appropriate in the circumstances. I do not believe it resulted in any unfairness to Andersen.

Andersen also made submissions concerning a 'regime' that it says was agreed with those assisting the Commission. I have reviewed the relevant correspondence referred to by Andersen. I am satisfied from that correspondence that no agreement was made (nor could it have been) whereby I would be limited in the scope of my

inquiry or report. In reaching many conclusions on technical auditing issues I have

The failure of HIH Insurance 67

placed some weight on the evidence of an auditing expert, Greg Couttas. His evidence was based on his examination of issues papers, to which Andersen had an opportunity to respond, and which formed the basis of the 'agreed regime' relied upon by Andersen. Accordingly, most of the findings in this chapter arise out of subject matter that was dealt with in the so-called agreed regime in any event.

Andersen submitted that it ought to be provided with a draft copy of this report before publication so that it could respond to my 'draft' findings . I did not consider that course to be either necessary or appropriate. Andersen has had notice of all issues from which adverse findings might arise by way of:

• correspondence with those assisting the Commission

• the production of issues papers by those assisting the Commission, to which Andersen had an opportunity to and did respond

• oral evidence, including the oral openings of counsel assisting and the cross­ examination of Andersen witnesses and other witnesses

• submissions of counsel assisting, which were the subject of detailed oral and written responses by Andersen.

I note Andersen's complaint that it has not had sufficient time to respond to any or most of those documents. However, as set out above, I consider the process adopted by the Commission to have been fair in all of the circumstances. Those circumstances include the time constraints imposed because of the need to deliver the report by the due date. I reject the submission that procedural fairness required that Andersen be provided with a draft version of this report before publication.

I reject also the submission that the general processes of the Commission were unfair. Where specific issues of procedural fairness have arisen, I have taken them into account where appropriate.

21.3 Audit approach

To ensure the quality of its audit work and to minimise its exposure to the risks of litigation and other adverse consequences, Andersen had in place a system of quality control policies and procedures. In the main, that system was spelt out in Andersen's 'Audit Objectives and Procedures' manual (AOP manual). 2

The AOP manual defined an audit in the following terms:

An audit is an examination of financial statements or other financial data made in accordance with generally accepted auditing standards . . . The overall objective of an audit is to express an opinion on whether the financial statements are presented fairly in conformity with generally accepted accounting principles.3

and further provided:

68 Th e audit function

As independent auditors, we may influence the form and content of the client's financial statements. However, while we may propose adjustments and modifications, in the final analysis the client's directors and management make the ultimate decisions in line with their overall responsibility for the representations made in the financial statements. 4

The AOP manual stated that Andersen's standards and policies5 were consistent with authoritative auditing standards and were to be observed in the conduct of each audit of financial statements.

The AOP manual further provided:

The standards and policies are part of the glue that binds us together as one Firm, providing the consistently high quality of auditing service necessary to attract and retain clients. In an environment in which public and governmental attention is increasingly focused on the quality of auditors' work, adherence to standards is essential. 6

The AOP manual was described as a research tool which set out the standards and overall policies that were to be observed in the conduct of audits. It also set out Andersen's overall approach to audits and identified auditing procedures that could be applied when appropriate. 7

The AOP manual stated that Andersen accepted accounting practices mandated by law , professional pronouncement or custom in countries in which public financial reporting was well established and there was a strong accounting and auditing profession. This was the case even where some of those practices did not conform to what Andersen considered to be the most appropriate standards. However, the AOP manual stated that Andersen did not regard an accounting practice as being

'generally accepted' merely because it was in use. Nor did Andersen accept any practice sanctioned in a particular country if the manner in which it was to be applied would result in the presentation of what Andersen would view to be misleading financial statements, taking into account the accounting and reporting environment in that country. 8

The AOP manual contained guidance for Andersen partners and staff in relation to matters such as the composition, responsibilities and performance of Andersen's audit teams using the business audit methodology. Some of those aspects are discussed in further detail in this section.

Auditing standards contain the basic principles and essential procedures for audit in Australia, with related guidance promulgated by the Australian Society of Practising Accountants and the Institute of Chartered Accountants in Australia. Auditing standards apply in addition to any ethical or legal requirements relevant to a particular engagement and apply to the audit of all financial reports. Within each auditing standard, the basic principles and essential procedures, which are identified

in bold-type (black lettering), are mandatory and are to be interpreted in the context of the explanatory text and other information contained in or appended to the auditing standard. 9

Th e failure of HIH Insurance 69

Unlike accounting standards which are enforced under the Corporations Act, auditing standards do not have the force of legislative sanction. They provide a benchmark against which the work of the auditor may be assessed. However, as I have said, a failure to comply with a relevant audit standard does not of itself amount to a breach of any legal duty and I have made no finding to that effect.

At the time ofthe 1999 and 2000 HIH audits, auditing standard AUS 206 dealt with the requirements for an audit firm's system of quality control. 10 AUS 206 placed an obligation upon an audit firm to implement quality control policies and procedures for the firm and for individual audits 11 and to communicate such policies and procedures to firm personnel. 12 Auditors were obliged to implement those policies and procedures which were appropriate to the individual audit. 13

Paragraph 6 of AUS 206 required sufficient direction, supervision and review of all work at all levels to provide reasonable assurance that the work performed met appropriate standards of quality 14, consultation within or outside the audit firm with persons with appropriate expertise whenever it was deemed necessary 15 and an ongoing review of existing clients 16 to facilitate the client retention decision.

Paragraph 17 of AUS 206 suggested:

The process of reviewing an audit may include, particularly in the case of large complex audits, requesting personnel not otherwise involved in the audit to perform certain additional procedures before issuing of the audit report.

Andersen's audit teams typically consisted of an engagement partner who was responsible for the overall supervision of the audit, an engagement manager, audit managers, audit seniors and more junior auditing and accounting staff. In some cases, audit teams could include a concurring partner, a reference partner17 and an advisory partner. 18' 19

The audit team for the 1999 audit of HIH comprised Alan Davies (engagement partner), Stuart Gooley (concurring partner), Jonathan Pye (senior manager), John Fanning (experienced manager), Rita Da Silva (experienced audit manager), Zita van de Walle (experienced audit senior), Sandor Helby (audit senior), Veronica Henderson (audit senior), Deborah Kelly (audit senior), Karen Khadi, Brendan Woods, Simone Solomon, Mandy Tran, Henry Partier, Jonathon Grant and Sebastian Dlugosz.

The audit team for the 2000 audit ofHIH comprised John Buttle (senior engagement partner), Jonathan Pye (support engagement partner), Craig Jackson (concurring partner), John Fanning (engagement manager), Sandor Helby (experienced audit senior/manager), Veronica Henderson (experienced audit senior/manager), Kerrie

Smith (experienced audit senior/manager), Karen Khadi (audit senior), Brendan Woods (audit senior), Neil Krawitz (audit senior), Kim Ly (audit senior), Henry Partier, Matthew McDonald, Linda Minassian, Sally Mason and Simone Sarroff.

70 The auditfonction

The audit was required to be planned and performed by the audit team under the overall supervision of the engagement partner. Andersen's AOP manual required that each member of the team only be assigned tasks for which he or she had adequate training and experience. Each audit team member was required to be supervised by a more experienced member of the team. 20

The adequacy of the performance of audit work by certain key members of the audit teams on the HIH audits is discussed below.

Andersen utilised a methodology termed the business audit in conducting the audits of HIH in 1999 and 2000. That methodology was described in detail in Andersen's AOP manual. The essential elements of the business audit process are described below.

The first stage of the process was for Andersen to consider, using a software tool known as 'SMART', whether to accept HIH as an audit client. 21 Andersen's decision to retain HIH as a client is discussed in further detail later in this chapter. The next stage of the process was for the audit team to 'understand HIH's business' by assessing HIH's business risk management processes and by performing a business analysis to identify and document risks.22 For each risk, the audit team was then to assess HIH's risk controls and determine whether there was any residual audit risk. If so, the audit team was to assess whether that residual risk could be reduced to a level acceptable to Andersen. 23

The consequences of the implementation of the business audit process are discussed below.

21.3.1 Audit methodology

Reliance on the work of others Counsel assisting submitted that a feature of the business audit process was a reduction in the substantive testing performed by the audit team in favour of increased reliance upon the client's control processes. One consequence was that no further audit work was required where the risks control design and the risk controls tested were evaluated as effective and the risk was considered to be reduced to an acceptable level. 24

Counsel assisting submitted that it was to be inferred that this change in focus was motivated, at least in part, by a desire on the part of Andersen to increase profitability by reducing the time spent by Andersen personnel on the audit. Counsel assisting submitted that such a desire was evident from statements contained within the AOP manual to the effect that a significant opportunity existed to achieve additional audit efficiency following the initial consideration of an individual risk using the business audit process. 25 It was also evident from Pye's memorandum to the files dated 12 January 2000 pertaining to Andersen's approach to the completion of risk control documents in respect of HIH26, and from the 1999

27 and 2000 28 audit

instructions sent to Andersen's overseas offices assisting in the HIH audit, which

Th e failure of HIH Insurance 71

placed pressure upon the audit team to increase their recovery of audit fees from HIH by adopting the business audit process.

Counsel assisting further submitted that the emphasis in the business audit process on increased reliance on the client' s risk control processes and the associated reduction in substantive testing increased the risk that the audited financial statements might have contained a material error.

Internal audit Counsel assisting submitted that, contrary to paragraph 2.6.1 of the AOP manual29 and paragraph 17 of AUS 604 (which required auditors to satisfy themselves as to the scope and effectiveness of the operations, policies and procedures of the internal audit function prior to their reliance on the work performed by that function), and notwithstanding the fact that Andersen had identified deficiencies in HIH's internal audit division30, Andersen relied upon the work of HIH's internal audit division without evaluating or testing it to confirm its adequacy in their conduct of the 1999 and 2000 HIH audits. In particular, it was submitted that Andersen relied upon the HIH internal audit division's work without performing a review of its working papers.

Counsel assisting further submitted that Andersen's reliance upon the HIH internal audit division's work in those circumstances evidences the pressure on Andersen to minimise the level of traditional audit work it performed, in order to improve both the profitability of its retainer with HIH and its relationship with HIH management.

Conclusion The submissions of counsel assisting as to the motivations of Andersen and the inferences to be drawn from the introduction of the business audit process and increased reliance upon internal audit were strongly disputed by Andersen. Having regard to the course of the inquiry concerning the audit as described above, those matters were not investigated in any detail. Accordingly there is insufficient evidence to make the findings sought by counsel assisting.

retention and risk management

Overview of SMART The client retention decision was the first stage of Andersen ' s internal risk management procedure. The decision was assisted by the use of computer software known as 'SMART'. 3 1

The 1999 AOP manual required that the audit team update the retention risk assessment at least twice during the course of the audit: after the assessment of residual audit risks and after completing all work (prior to the sign-off date). The 1999 AOP manual also required that an assessment be made prior to arranging each year's audit engagement. 32 The 2000 AOP manual required an annual assessment to be made using SMART prior to arranging each year's audit engagement.33 For engagements previously assessed as maximum* 34, maximum or high risk35, the SMART assessment was required to be completed at least six months prior to the client's year end. 36

72 The audit function

The 1999 AOP manual provided that for each maximum risk engagement, the engagement partner was to document the rationale for accepting or retaining the engagement, the critical risks and how they would be managed and the adequacy of the engagement team to deal with those issues. For maximum and maximum* clients, such as HIH, at least the audit division head and assurance and business advisory (ABA) practice director were required to approve retention of the client. 37 The 2000 AOP manual provided that for maximum and maximum* risk clients, such as HIH, the audit division head, ABA practice director, country ABA partner and the engagement partner were required to approve retention of the client. 38 The

involvement and assistance of senior Andersen personnel was required to manage the risks associated with the highest risk clients and to ensure that those risks were reduced to an acceptable level. 39 Their involvement was intended to focus on specific risks to which Andersen had the greatest exposure and was to include procedures such as risk management meetings and the formulation of risk management plans. 40

Th e decision to retain HIH as a client The Andersen audit team applied SMART to assess the risk that the retention of HIH as an audit client posed to Andersen, including the assessment of a number of detailed 'risk drivers'. This process culminated in an ultimate classification of risk. From 1998 to 2001 41 , HIH was assessed as a maximum risk client. Despite that assessment, the decision was made to retain HIH as an audit client in each year with limited apparent consideration of the risk identified by Andersen's own procedures. Each year, the same reason was given for that justification, namely that HIH was a longstanding client of Andersen's Sydney office and that Andersen's experience with HIH enabled it 'to satisfactorily manage the risk' .42 The rationale for the decision to retain HIH as a client endured notwithstanding changes in HIH' s management, Andersen's audit team, HIH's financial position and the relationship between Andersen and HIH.

The question of Andersen's retention of HIH as a client was considered again by Buttle, Jackson, Davies and Garry Hounsell in October 2000, only months before HIH finally collapsed. Jackson, Davies and Hounsell were of the view that Andersen probably ought not audit HIH any longer because of its aggressive accounting practices and the difficulty experienced by Andersen in resolving issues with HIH management. In contrast, Buttle considered that Andersen should retain HIH as an audit client because Andersen had worked very hard to get a proper conclusion on HIH's 30 June 2000 accounts and because Andersen ' s concern for its reputation would not have been a sufficient reason for ASIC to approve its resignation. 43

Consultation Senior Andersen personnel were made aware of the risk associated with HIH by way of Andersen's practice director reporting procedure. Section 2.3 44

of the AOP

manual provided for consultation with ABA practice directors and other senior members of Andersen in relation to significant auditing, accounting, financial statement presentation or reporting problems.

The failure ofHIH Insurance 73

The engagement partner had responsibility and authority to resolve all client issues. 45 Issues were initially required to be resolved by the audit team identifying and researching the relevant issues and forming preliminary conclusions. Consultation was required if the engagement partner continued to have any question about the conclusion reached. The audit team was then to communicate the final resolution of the issue to the client and any others consulted.46

Consultation with an ABA practice director was required if the audit team's assessment of how to reduce Andersen's risk to an acceptable level was highly judgmenta1. 47 Consultation was also required if there was a significant issue in relation to a maximum risk client, such as HIH. 48

Each of the 1999, January 2000, August 2000 and 2001 SMART reports for HIH recorded that consultations had been held with others in the prior year in relation to PAJEs (proposed adjusting journal entries). 49 The plan to manage the risk associated with those adjustments envisaged that any issues would be canvassed in consultations with the practice director and others. 50

Senior Andersen personnel Christopher Knoblanche was the country managing partner from 1998 until 2001 and regional managing partner from 1999 until April 2002. As country managing partner, Knoblanche oversaw the operations of Andersen's businesses, with limited client involvement and limited contact with engagement partners. In his role as regional managing partner, Knoblanche coordinated a number of Andersen partnerships in Australia.

Terry Underwood was managing practice director (Asia Pacific) from 1998 to 2002 and was involved in risk and litigation management for the ABA Andersen practice in the Asia Pacific region. Within that region, he had responsibility for supervising and consulting with various local and regional practice directors in relation to risk management, litigation and various technical issues.

Jackson was the practice head of the ABA practice in Sydney from 1999 until May 2002. He gave evidence that he was conscious of the need for HIH to be given 'specific attention from senior practitioners in the audit practice group'. 51

Gooley was the accounting and audit practice director for Australia and New Zealand from December 1990 until 1 February 2000 and, in this role, was usually consulted by engagement partners on 'significant, unusual or judgmental issues encountered during an audit'. In this capacity, Gooley also had monthly telephone calls with Underwood to advise him on major issues, including the status of issues arising from the HIH audit.

Davies was removed as the HIH audit engagement partner in 1999 and became the practice director of the ABA practice in Sydney in March 2000. In that capacity, Davies oversaw all of the risk management policies adopted by Andersen in connection with its issue of audit opinions. On occasion, Davies was involved in consulting with the partners responsible for the HIH audit.

74 The audit function

Practice directors attended regular meetings to review adherence to firm procedures and policies and to raise any concerns held by individual practice directors. 52 Periodic practice reviews were conducted in Australia. 53

Awareness of the risk In accordance with the above procedures for reporting to senior Andersen personnel, Andersen Australia (in particular, Gooley as the relevant national practice director) had various communications with Underwood (then regional practice director) in relation to HIH. Issues raised included whether retirement benefits should be restricted upon the appointment of a retired partner to the board of an audit client54, and Gooley's nomination of HIH as the second highest risk/profile client of Andersen Australia. 55 Underwood said he had no specific memory of the ABA area service line leader and regional managing partner being briefed on that nomination. 56 Underwood stated that by February 2001 HIH had become Andersen's number one risk client in Australia. 57

Risk management steps taken The usual Andersen process was that a risk management plan for each maximum risk client (such as HIH) was prepared by the engagement team and approved or reviewed by the service line leader, country managing partner and practice director. 58 No formal risk management plan for HIH was produced by Andersen, even though HIH was consistently assessed as high or maximum risk over an extended period of time. 59

In November 2000 HIH was identified as a client for which expanded risk management procedures were required. Hounsell requested that the HIH audit team produce its risk management plan. 60 The audit team was unable to do so and produced instead the agenda of an upcoming management meeting. 6 1 There is no evidence that the audit team's failure to produce a risk management plan was pursued by Hounsell or other senior Andersen persbnnel.

Internal Andersen meetings in relation to HIH risk management were held on 18 January and 19 February 2001 to consider the expanded risk management directive received from Hounsell.62 Buttle, Jackson, Davies, Knoblanche and Pye were recorded as having attended the meeting on 18 January 2001. 63 No evidence of any earlier meeting was located even though HIH was rated a maximum risk client

in earlier years.

There is little evidence that senior Andersen personnel took any effective action in respect of the risks identified in auditing HIH. Even during the final days of HIH in February and March 2001, the risk management role played by the regional practice directors was limited to 'monitoring' the situation and considering the options available to Andersen in the event of litigation.

64

Correspondence passing between Underwood and various senior Andersen personnel during this period indicated that, despite Andersen's assessment of HIH as its number one risk client, they were of the view that Andersen was 'better off

The failure ofHIH Insurance 75

remaining as HIH's auditor than resigning and that the risk of retaining HIH as a client was ' less now than 6-8 months ago'. 65

Conclusion The SMART process provided Andersen with a detailed and rigorous identification and management framework and planning process such that it had available an effective and efficient system for the early identification and management of significant risk. Andersen consistently utilised SMART between at least 1998 and 2001 to assess HIH as a maximum risk client66 and therefore recognised the substantial risk that auditing HIH posed to the firm and its reputation.

Andersen failed to take effective action properly to manage that risk, despite the requirements of paragraphs 6 and 8 of AUS 206 and the AOP manua1. 67 In particular, the evidence68 shows that the audit team failed to formulate a formal risk management plan in circumstances where HIH was assessed as Andersen's second highest risk client in Australia69 and was identified as a client for which expanded risk management procedures were required. 70

In addition, it appears that senior Andersen personnel took no action to ensure that the risk management plan was indeed formulated and to monitor carefully the implementation of whatever risk management actions were identified in the plan. 71 Andersen had recognised HIH as being a client in respect of which or

'very high' 73 attention was to be received from senior management. The involvement and assistance of senior personnel in the management of the firm's highest risk clients, to ensure that such risks were reduced to an acceptable level, was specifically contemplated by the AOP manual. 74

Underwood, whose role involved taking positive action to ensure that risk and litigation management issues were considered and resolved, was made aware by Gooley of HIH's status as Andersen's second highest risk client. 75 However, it appears that he took no action to ensure that the ABA area service line leader and regional managing partner were briefed in relation to the risk so that risk management procedures could be implemented. 76

Andersen did not address the risk that HIH posed to it even though HIH became Andersen's highest risk audit client in Australia. 77 Rather than taking concerted action to deal with the increased risk posed by HIH, for example by squarely addressing, both within Andersen and with HIH, the factors that gave rise to the risks and whether they could be mitigated or eliminated, Andersen's regional practice directors limited their involvement simply to monitoring the situation and considering the options available to Andersen in the event of litigation. 78

I find it surprising that, despite the clear risk that HIH posed to the firm and its reputation, Andersen decided to retain HIH as a client without a carefully constructed risk management plan. Such a plan could, for example, have addressed how Andersen should assess the reliability of the actuary on whose work Andersen relied in relation to the most significant liability of HIH. I have dealt with this matter in Section 15.12.3.

76 The audit function

21.3.2 Involvement of key Andersen personnel

Engagement partners

Pursuant to s. 2.1 .1.1 of the AOP manual, the engagement partner had ultimate responsibility for the quality of an audit and the resulting auditors' report. 79 To discharge that responsibility, the engagement partner was expected to take and to adhere to various steps and procedures. 80 These included the review of working papers to the extent necessary to be satisfied that they contained adequate evidence of the work done and the conclusions reached and that they supported the report to be issued. 8 1

In this regard, the AOP manual suggested that the engagement partner should review, at a minimum, the business risk model and related risk maps, business risk control documents (BRCDs), PAJE and proposed reclassifying journal entries (PRJE)

82

schedules, financial statement drafts, the auditors' report, audit work originated by the engagement manager and any additional areas that required the engagement partner's involvement and judgment. The AOP manual also suggested that the engagement partner consider more extensive reviews of the working papers

if he or she believed that such a review was warranted. 83

Counsel assisting submitted that Davies and Buttle carried out insufficient audit work to discharge their responsibilities as engagement partners. In its response Andersen pointed to a passage in the AOP manual 84 which suggested 'the segregation or highlighting of particular audit work to be reviewed by the engagement partner to provide a focus for the partner review'. 85 Andersen submitted that this envisaged a regime where necessary assistance could be provided to the engagement partner to carry out that role. 86 In my view, to carry out his functions properly the engagement partner would still have to review sufficient working papers and have sufficient personal knowledge of the matters contained in them. This is especially so in light of the complexity and high risk nature of the HIH audits.

Davies and Buttle were engagement partners in respect of the 1999 and 2000 HIH audits respectively.

Davies Davies gave evidence that his practice was to review the conclusions of the engagement team with them to confirm whether such conclusions appeared appropriate in the circumstances. Davies stated that he did not look at the supporting documentation, audit work or working papers because he expected that all of the audit work and working papers were supervised and reviewed by a senior team member. 87 In this regard, Davies delegated responsibility for the day-to-day conduct of the 1999 audit of HIH to Pye. 88

Andersen time sheets recorded that during the periods 4 March 1999 to 30 June 1999 and 1 July 1999 to 9 September 1999, Davies spent 32 hours and 25.5 hours respectively on the HIH audit engagement.

Th e failure of HIH Insurance 77

Andersen submitted that the suggestion that insufficient time was spent on the 1999 audit by Davies was not put to him by counsel assisting and that Davies was not asked to confirm whether the time he recorded represented all of the time spent by him on the audit. Andersen also argued that the issue of the sufficiency of time spent on the audit was both a matter of professional judgment and one which was not the subject of expert evidence. The sufficiency of time spent by Davies on the audit was raised in a background paper89, to which Andersen had an opportunity to (but did not) respond and which contained a summary of Davies' time sheets. In any event I do not consider Davies' time sheets provide a sufficiently reliable basis upon which to make a finding and I place no reliance upon them. Indeed, I would take a lot of persuading that time sheets are a reliable guide to anything.

On 9 September 1999 Davies 90 signed an audit review questionnaire in respect of the 1999 audit of HIH indicating that he had fully discharged his responsibilities and that, prior to the signing and release of Andersen's audit report, the items set out in the questionnaire had been performed. 91 Such items included that the working papers constituted an adequate record of the work done and conclusions reached and provided a reasonable basis for the opinion formed, and that all matters raised during the course of the audit that could materially impact upon Andersen's auditors' report on the financial statements had been satisfactorily resolved and documented in the working papers. 92 The questionnaire stated that to be

'meaningful' those representations were to be based on his 'personal knowledge'. 93 Davies made those representations. 94 In his evidence, he said that he did not review the majority of the audit team's working papers during the course of the 1999 audit. 95

As audit engagement partner, Davies was ultimately responsible for the quality of Andersen's 1999 audit and the audit opinion Andersen formed. 96 In Section 21.5 I have found that there were deficiencies in the gathering of audit evidence in relation to various issues in the 1999 audit. These findings are based largely on the audit working papers. Had Davies made a personal review of more of the audit papers, some of these deficiencies might have come to light. That aside, I make no finding that Davies spent insufficient time on the 1999 audit.

Buttle In respect of the 2000 audit of HIH, Buttle was supported by Pye, the designated 'support' or 'second' engagement partner. Pye presented to Buttle the developed position in respect of the 31 December 1999 half-year review. 97 In the course of his review of the accounts and the audit work that had been carried out in relation to the review, Buttle saw some of the working papers and presentations relevant to the previous year's audit of HIH. 98 Although Buttle took full responsibility for the audit opinion in respect of the half-year review, he had limited knowledge of the underlying working papers and relied substantially upon Pye's knowledge of the underlying issues. Buttle did not have sufficient knowledge of HIH to be m a position to rely on his own personal knowledge of such issues. 99

78 The auditfimction

Although the extent of Buttle's audit work in respect of the 2000 audit of HIH is unclear from the evidence, Andersen time sheets recorded that during the period 15 November 1999 to 16 October 2000, Buttle spent 111.5 hours on the HIH audit engagement. Buttle gave evidence that, whilst he charged for all time spent on the audit, his time may not have been fully recorded in his time sheets. 100 That evidence accords with my own experience of time sheets and I accept it.

Andersen submitted, as it did in relation to Davies, that counsel assisting failed to put to Buttle the suggestion that he spent insufficient time on the 2000 audit and that the issue of the sufficiency of time spent on the audit was both a matter of professional judgment and one which was not the subject of expert evidence. For the reasons I gave earlier, I place no reliance upon the time sheets ofButtle.

Throughout the period from October 1999 to October 2000 Buttle was primarily occupied with building and leading Andersen's local and international financial services practices. 101 Buttle was recruited in October 1999 from KPMG to develop Andersen's financial markets practice and he was perceived by the firm to be a

'rainmaker' in terms of his ability to develop the practice and the firm's market share. 102 In September 2000, he was appointed ABA head of Andersen's financial services industry practice in the Asia Pacific region. 103

On 16 October 2000 Buttle and Pye signed audit review questionnaires which contained representations as to the sufficiency of the audit working papers and other matters, similar to those signed by Davies in 1999. 104

In addition, the 2000 audit review questionnaire also required the engagement partner and engagement manager to represent that they had personally reviewed the relevant working papers documenting the items listed in Part I of the questionnaire relating to specific quality control procedures and to represent that they were satisfied that the matters had been properly considered and documented.

105

Buttle was ultimately responsible for the quality of the 2000 audit and the audit opinion of Andersen. 106 There is no clear evidence as to the extent to which Buttle personally reviewed the audit working papers or his reliance on Pye in this respect. Again by reference to the findings in Section 21.5, various inadequacies in the gathering of audit evidence did not come to Buttle's attention during the process of

review of the working papers. I do not, however, make any finding that Buttle spent insufficient time on the 2000 audit.

Concurring partners Gooley and Jackson were the concurring partners in respect of the 1999 and 2000 audits respectively.

Responsibilities The concurring partner was responsible for concurring with the scope and extent of consultation and with the resolution of all significant accounting, auditing and reporting issues. 107 Review by a concurring partner did not relieve the audit

engagement partner from final responsibility for the issue of the audit report. The

The failure ofHIH Insurance 79

concurring partner's role was to monitor the execution of the engagement partner's final responsibility by performing an objective review that served as a basis for concurrence with the engagement partner' s decisions on key issues.108

Andersen's AOP manual required a concurring partner review of audits of public entities, entities assessed as maximum risk and certain other audit engagements or attest work where significant risk existed (including insurance companies that filed statements with a regulatory agency). 109 Since HIH was both a public insurance company and an engagement assessed as maximum risk, a concurring partner review was required in respect ofthe 1999 and 2000 audit engagements.

The assignment of a concurring partner was the responsibility of the office managing partner. For maximum risk audits, such as HIH, the appropriate ABA practice director was required to approve concurring partner assignments in connection with his or her approval of SMART. A concurring partner was required to have sufficient technical expertise and experience, be independent of the engagement team, possess sufficient years of experience, and have achieved a level of responsibility and position relative to the engagement partner to ensure his or her ability to carry out the concurring review responsibilities with objectivity and due professional care. A concurring partner was also required to be familiar with relevant specialised industry practices and the relevant securities and exchange rules

d I

. 110

an regu atwns.

The AOP manual suggested that the concurring partner should hold discussions with the engagement partner regarding material accounting and auditing issues 111 , read the financial statements and auditors ' report 112 and review sufficient working papers to decide whether to concur with the engagement partner's decisions on material accounting, auditing and reporting issues. 11 3 The 1999 AOP manual (and the AOP 99-18 update) set out the working paper review requirements for moderate/low risk engagements and significant risk engagements. Those working paper requirements were more onerous in respect of maximum or high risk public engagements such as HIH. The 1999 AOP manual expressly stipulated that certain types of working papers should be reviewed by the concurring partner in the case of such engagements. 114 The 2000 AOP manual expressly stipulated that certain types of working papers, at a minimum, should be reviewed by the concurring partner on every engagement. 11 5 For maximum risk audits, the AOP manual also suggested that the concurring partner should ensure that the appropriate risk management plan was satisfied and that this was to be done through discussions with the engagement team and/or review of the applicable working papers, to ensure that only additionally required monitoring steps had been performed. 11 6

The concurring partner review was required to be completed prior to the release of Andersen's auditors' report. 11 7 In addition, in the case of public audit clients rated maximum*, maximum or high risk, such as HIH, the concurring partner was required to perform a 'timely' review, being a review completed in sufficient time to · allow for the implementation of any agreed revisions proposed by the concurring partner to the risk reduction approach. 11 8

80 The audit fonclion

Given HIH's classification as a maximum risk engagement, the question arises whether Gooley, in 1999, and Jackson, in 2000, fell short of the requirements of paragraphs 6 and 17 of AUS 206 and Andersen's own requirements as set out in the AOP manual.

Gooley Gooley had limited, if any, prior specific insurance experience 119, despite the requirement of s. 2.4.3 of the AOP manual. 120 This limited his ability to perform an expert review of Davies' decisions on material accounting, auditing and reporting

issues. Given the nature, size and complexity of the HIH engagement, the need for Gooley to have specific insurance industry experience was heightened.

As concurring partner in respect of the 1999 audit of HIH, Gooley was required to sign and initial the audit review questionnaire. He does not appear to have done so. 121 Andersen's audit opinion in respect of the 30 June 1999 financial statements was signed by Davies on 9 September 1999. 122 However, the completed audit review questionnaire was not faxed to Gooley until 20 September 1999. 123 In a handwritten letter to Davies dated 21 September 1999 124 which set out Gooley's concerns in relation to the 1999 audit 125 , Gooley stated that he had not signed the questionnaire 'pending the resolution of those issues'. Gooley said that he could not recall whether he had any discussions with engagement personnel subsequent to 21 September 1999 in relation to the issues that he had raised and the documentation that he had requested. 126

Counsel assisting submitted that Andersen time sheets recorded that Gooley spent 7.4 hours on the 1999 HIH audit during the period 17 February 1999 to 30 September 1999. 127 Gooley recorded 1.1 hours of work in relation to the 1999 audit of HIH during the period August 1999 to 9 September 1999 128, being the period immediately preceding the signing of the auditors' report on

9 September 1999.129 Gooley's time sheets recorded 0.5 hours in relation to the 1999 audit of HIH after 13 September 1999, for work performed on

30 September 1999.130 No time was recorded between the period 14 to 29 September 1999.

Andersen submitted that Gooley was not asked by counsel assisting to confirm that his time sheets were accurate or recorded all time devoted by him to the audit. I note that the issue of Gooley's time spent on the HIH audit was raised in a background paper 131 which contained a summary of Gooley's time sheets and to which Andersen had an opportunity to (but did not) respond. However, I place no reliance upon the

time sheets of Gooley, for the reasons I have identified above.

Andersen also submitted that Gooley was not asked whether, in his judgment, the time that he spent on the audit was adequate. I do not consider that I would have been assisted by Gooley's answer to that question.

The fact that Gooley only received the review documentation on 20 September 1999 132 together with his evidence that he did not recall following up on or

Th e failure of HI HI nsurance 81

resolving the issues that concerned him in the 1999 audit suggests to me that Gooley would have had very little time to deal adequately with the 1999 audit issues.

Since the concerns raised by Gooley in respect of the 1999 audit do not appear ever to have been resolved 133 and the 1999 review questionnaire signed by Gooley was not produced to the Commission, it appears that Gooley did not formalise or complete the 1999 concurring partner review in respect of the HIH audit, despite the requirements of s. 2.4.2 of the AOP manual 134 and paragraphs 6 and 8 of AUS 206. 135 The evidence 136 suggests that the 1999 review was neither performed prior to the release of the 1999 auditors' report 137, nor in sufficient time to allow for a

'timely' review to be conducted, despite the requirements of ss. 2.4.1 138 and 2.4.4 139 of the AOP manual.

I have taken into consideration Andersen's submission to the effect that Gooley was not examined as to whether the review was conducted on a 'timely' basis, but that had he been asked, he would have said that he believed that the review was completed in sufficient time to enable changes to be made should that have been necessary.

I have also taken into consideration Andersen's submission to the effect that Davies gave evidence that he believed that Andersen's 1999 audit opinion was issued in mid to late September 1999 but that it had been signed before then and that changes were made to the financial statements between the date of signing and the opinion's issue. 140 Andersen also submitted that, had Gooley been asked about the matter, he would have said that he believed the draft financial statements were amended in some respects after his review and before the release of the financial statements. In this regard, paragraph 35 of AUS 702 stated:

The audit report should be dated as of the date the auditor signs that report ... Dating the audit report informs the user that the auditor considered the effects on the financial report and on the audit report of those transactions and other events that occurred up to the date cited and of which the auditor became aware.

AUS 702 does not countenance the performance of audit work subsequent to the date of the audit report. If there were changes to the financial statements between 9 September 1999, when the audit committee met and the accounts were signed, and a later date in September when the audit opinion was issued and backdated, I consider the lateness of consulting Gooley would necessarily have inhibited his contribution. In those circumstances it is difficult to see · how he could have contributed fully in the manner expected of a concurring partner by Andersen's audit methodology and procedures.

In light of Andersen's assessment of the HIH audit as maximum risk, the requirements of AUS 206 and the AOP manual, it is surprising that Gooley did not perform a more significant role in the 1999 audit of HIH.

82 The audit function

Jackson Jackson also had limited, if any, specific insurance experience 14 1, despite the requirements of s. 2.4.3 of the AOP manual. 142 That lack of experience limited his ability to undertake an expert review of Buttle's decisions on material accounting, auditing and reporting issues. Given the nature, size and complexity of the HIH engagement, the need for Jackson to have specific insurance industry experience was heightened.

In relation to the 2000 concurring partner review 143, Jackson represented in the audit review questionnaire that he had discussed with the engagement partner the significant accounting, auditing and/or reporting issues, verified that any agreed risk management plans were completed and that the additional monitoring steps were performed. Further, that he had reviewed the documentation specified in the questionnaire, including selected working papers and a draft of the client's principal financial statements and Andersen's auditors ' report.

Jackson gave evidence that he did not have access to the 2000 audit working papers. 144 He stated that he did not review documentation outside of the accounts and outside of the key issues raised by Buttle and Pye and discussed with Davies and others. 145 Jackson signed off as the concurring partner to indicate that the relevant documentation had been reviewed. 146

Jackson gave evidence that he did not believe that he was acting in the capacity of concurring partner in respect of the 2000 audit of HIH and that he thought that he was being consulted as the Sydney practice head of ABA. 147 Jackson' s belief was inconsistent with Davies' belief that Jackson was the 2000 concurring partrier

148 and

with Gooley's email to Davies dated 10 January 2000 in which he suggested to Davies that his involvement in the HIH audit be limited to an advisory rather than concurring partner role and that he could resume the role of concurring partner in 'a couple of years' .149 It was also inconsistent with Jackson' s act of signing the concurring partner review. 150

I find it surprising that there was uncertainty within Andersen about the identity of the concurring partner. If Davies and Gooley believed that Davies was not the concurring partner then it is reasonable to assume that the involvement of Davies in the 2000 audit was tailored accordingly. If Jackson thought he was not the concurring partner then I assume his participation was al so tailored according to that belief.

Jackson inserted the date 16 October 2000 on the 2000 audit review

questionnaire 15 1, the same day as the independent audit report was signed by Buttle. 152 Jackson gave evidence that he did not receive the questionnaire until some months after 16 October 2000, but that a date of 16 October 2000 was inserted by him to comply with Andersen policy.153 Jackson stated that at the time of signing the questionnaire, he knew that '16 October 2000' was not the actual date that he signed

the questionnaire. 154

Th e failure of HIH Insurance 83

Andersen submitted that Jackson's review was not backdated (as had been submitted by counsel assisting) because it was signed by him to reflect the date at which the statements made in the review were correct. However, Jackson gave evidence that when he wrote the date of 16 October 2000, he knew that it was not the date that he was signing the review.155 In my view, by signing the review as at

16 October 2000, Jackson was representing that he had discharged hi s responsibilities as concurring partner as at that date.

The evidence 156 suggests that the 2000 review was neither performed prior to the release of the 2000 auditors' report, nor on a 'timely ' basis, despite the requirements of ss. 2.4.1157 and 2.4.4 158 of the AOP manual.

Despite the requirements of ss. 2.4.5 :i 59 and 2.4.5.3 160 of the AOP manual and the representation made by Jackson in the 2000 audit review questionnaire as to his review of the relevant documentation 161 , Jackson did not review the 2000 audit working papers

162 and the financial statements of HIH in full , but rather relied upon others 163 to do so. Jackson predominantly confined his participation in the audit to attendance at meetings. 164 As a consequence, I find it unlikely that Jackson had a sufficient documentary foundation upon which to deal with all of the key issues arising in the 2000 audit.

In making the above findings, I have taken into consideration Andersen's submissions that there was nothing in the AOP manual or SMART which precluded more than one person fulfilling the role of concurring partner and that Jackson's reliance, in part, on the work of others was not contrary to the requirements of the AOP manual.

However, the AOP manual spoke consistently in terms of a single concurring partner who was to carry out the review. Further, the AOP manual provided for the appointment of a concurring partner with specific attributes. In any event, only one concurring partner was designated by Andersen in respect of the 1999 and 2000 audits.

As .to Jackson's reliance on others, I note that he was required to make representations to the effect that he had discharged his responsibilities as concurring partner. Although s. 2.4.5 of the AOP manual 165

contemplated the possibility that a

concurring partner might consult with other partners of the firm, such consultation was to be sought in addition to, and not in place of, the concurring partner carrying out the specific procedures required.

In light of the assessment of HIH as a maximum risk audit cliene 66, the size and complexity of the engagement and the requirements of paragraphs 6 and 8 of AUS 206 167, a more extensive review of the working papers and underlying documentation should have been performed by Jackson to provide additional support to Buttle, who was the newly appointed engagement partner. It is surprising that Jackson did not perform a more significant role in the 2000 audit. But perhaps· the most extraordinary feature is Jackson' s uncertainty as to whether he was the concurring partner at all.

84 The audit fUnction

No satisfactory explanation was given by Andersen for the absence of any significant participation in the 2000 audit by a concurring or review partner. As a consequence, the HIH audit did not receive the benefit of a proper objective review of the engagement partners' decisions on key issues.

21.4 Relationship between Andersen and HIH

That an auditor must be independent both in fact and in appearance is fundamental to an effective audit.

The concept of 'appearance' of independence has to be given meaning. It is similar to the well-known adage that justice must not only be done but be seen to be done. It is fundamental that the auditor be independent and be free of conflicts and other impediments which create the risk of hi s or her independence being compromised. Appearance of independence is important because, again to resort to an old adage, many people judge books by their covers. In the context of audit, matters that affect the appearance of independence can undermine the confidence that a user of the accounts may place on the audit opinion.

21.4.1 The requirement of independence

During the 1999 and 2000 audits of HIH, the requirement of independence was contained in paragraph 4 of auditing standard AUS 202. AUP 32 provided guidance regarding that requirement. In addition, the Joint Code of Professional Conduct 16& included a statement about independence.

Andersen submitted that the criteria set out in AUP 32 paragraph 9 and the joint code by which the question of 'perceived independence' is to be answered are not clear. It refers to the fact that the current requirement of the joint code does not speak in terms of 'perceived independence' , although it states a member 'must both be and be seen to be free of any interest which is incompatible with objectivity'.

In my view the professional pronouncements were sufficiently clear. They emphasised the importance of the auditor being, and being seen to be, independent. AUP 32 defined actual independence as 'the achievement of actual freedom from bias, personal interest, prior commitment to an interest, or susceptibility to undue

influence or pressure' .169 Perceived independence was defined as 'the belief of financial report users that actual independence has been achieved' .170 AUP 32 required auditors not to act in a manner which may cast doubt on their independence. 171

Those professional pronouncements emphasised the importance to the audit process of an auditor who is, and who is perceived to be, independent of the audit client. My analysis of Andersen's relationship with the HIH board and management proceeds on that basis.

Th e failure ofHIH Insurance 85

Aspects of Andersen's relationship with HIH that affected the perception that Andersen was independent are discussed below. The separate, but related, question of whether Andersen's independence was actually compromised cannot be adequately considered without first analysing Andersen's performance of the 1999 and 2000 audits. I return to that question later in this chapter.

21.4.2 Background to Andersen's relationship with HIH

Andersen was appointed auditor of HIH when HIH joined the Heath group in 1971. 172 By at least 1999, if not earlier, HIH was a significant client of the Sydney audit practice of Andersen. 173

The annual reports of HIH indicated that Andersen received the following fees from the HIH group. 174

Financial year ending 31 December 1997 30 June 1999 30 June 2000

Audit fees $980 000 $2 417 000 $1 700 000

Non-audit fees $436 000 $757 000 $1 631 000

Total

$1 416 000 $3 174 000 $3 331 000

Andersen submitted that the figures included fees received by overseas partnerships of Andersen and that the figure for 'non-audit fees' included some fees related to audit work. I do not consider that those matters contradict or qualifY the proposition that HIH was a significant client of Andersen's Sydney audit practice.

Counsel assisting submitted that the changing nature of Andersen's relationship with HIH affected Andersen's independence from HIH. On 7 January 1999 Ray Williams told Knoblanche that HIH's relationship with Andersen was 'as strong as ever'. 175 But on 29 April 1999 Fodera told Knoblanche, on behalf of Williams, that the relationship had gone from 'one of the very best' to 'absolute rock bottom' . 176 Andersen's strong relationship with HIH management apparently deteriorated in

1999 after Davies and Gooley met Head and Gardener, who were members of the HIH audit committee, in the absence of HIH management. That matter is discussed further below.

21.4.3 Former Andersen partners on the board of HIH

From December 1998 the HIH board contained three former partners of Andersen, namely Cohen, Fodera and Gardener. 177

Cohen was chairman of the board and a non-executive director of HIH from 20 January 1992. He was chairman of the HIH audit committee from August 1999 to February 2001. 178 Cohen had been a partner of Andersen from 1965 until his retirement on 31 August 1990. 179 Cohen's appointment to HIH was supported by Gardener, who was then HIH's audit partner. 180

86 The auditfimction

Cohen received the following benefits from Andersen whilst he was a director of HIH:

• fees from a consultancy arrangement with Andersen. From 19 August 1992 to 21 August 2002 he received $190 877.60 in relation to the consultancy arrangement, including $5400 in 1998, $4798 in 1999 and $2400 in 2000 18 1

• a monthly retirement benefit, indexed annually. 182 Cohen gave evidence that it was the same benefit received by retired partners of Andersen worldwide 183

• an office, including secretarial support, at Andersen' s Melbourne office until April2000 184

• stationery supplied by Andersen until April2000. The letterhead consisted of Cohen' s name and the address of Andersen' s Melbourne office 185

• an annual subscription to an accounting body of Cohen's choice 186

• payment of Cohen's auditor's and liquidator's licences 187

• coverage by Andersen's professional indemnity insurance in respect of work that Cohen performed for Andersen. 188

Counsel assisting submitted that the Consultancy agreement between Cohen and Andersen might have breached s. 324(2)(h) of the Corporations Law. Insufficient evidence was led concerning, for example, the extent to which Cohen was engaged in ' accounting or auditing matters ' under the arrangement. I make no finding that there might have been a contravention of s. 324(2)(h).

Neither Cohen's consultancy arrangement, nor his receipt of retirement benefits from Andersen was disclosed to the HIH board or disclosed in HIH' s annual report. 189 In 1998 and 1999, Cohen suggested to Williams that HIH receive tenders from other auditors, but Williams rejected that suggestion. 190

Fodera joined HIH on 1 September 1995 as chief financial officer 19 1 and was an executive director from 10 May 1997 to 12 October 2000. 192 He was a partner of Andersen from 1990 until he resigned to join HIH. 193 Fodera was the junior Andersen partner on the HIH audit team from 1990 to 1993 (during which time

Gardener was the engagement partner) and was the engagement partner in 1994.194 In his role at Andersen, Fodera worked closely with members of the HIH audit team and had a particularly close relationship with Pye. An Andersen performance evaluation of Pye noted that Pye had a very strong relationship with Fodera. 195 Fodera provided Pye with an oral reference in relation to his promotion as a partner of Andersen. 196

Gardener was a non-executive director ofHIH and a member of the audit committee from 2 December 1998. 197 He was appointed chairman of the audit committee in February 2001. 198 He had been a partner of Andersen from 1972 199

until his

retirement on 30 June 1998?00 Gardener was the Andersen engagement partner on the HIH audit team from 1973 to 198920 1 and was the concurring partner from 1990

Th e failure ofHIH Insurance 87

to 1993, 1996 and 1997.202 In the course of his audit work, Gardener developed a relationship with Williams whereby Williams considered Gardener to be more than HIH's auditor and a 'true business advisor' .203 Gardener introduced Cohen, then a recently retired Andersen partner, to Williams in 1992.204 Gardener received retirement benefits from Andersen of approximately $40 000 per year. 205

As the third of three former Andersen partners to be appointed to the board of HIH, Gardener's appointment in December 1998 was cause for concern amongst at least Davies and Gooley. The other directors of HIH gave evidence that they were not concerned about the presence of three former partners of Andersen on the board or the audit committee.206 Davies gave evidence that at the time of Gardener's appointment, he had some concerns about the effect the presence of three former Andersen partners on the board of HIH might have on the perception that Andersen was independent ofHIH.207 Gooley raised the matter with Underwood, who in tum raised it with Robert Kutsenda (Worldwide practice director head) and Gary Goolsby (US practice director head)?08 Gardener gave evidence that although there might have been a perception that Andersen was not independent, he did not have such a perception. He considered it to be a matter for Andersen. 209

Andersen submitted that the presence of its former partners on the board of HIH was a factor relating to its perceived independence which was required to be and was considered. Andersen's independence was the subject of public comment by the Association of Institutional Shareholders in Australia and by the media. In my opinion, the fact that Andersen's independence was questioned in this way suggests that users of HIH's financial reports might have had a perception of a lack of independence.

I consider that the presence ofCohen, Gardener and Fodera as HIH directors and in the case of Cohen and Gardener, audit committee members, having regard to the professional antecedents and continuing links with Andersen as described above gave rise to a perception that Andersen was not independent of HIH. I return to the question of whether Andersen's actual independence of HIH was compromised at the end of this chapter.

21.4.4 Andersen's dealings with HIH

Key members of the Andersen engagement team (usually the audit engagement partner and another) typically met the HIH audit committee tw.ice in respect of each balance date for full year audits and once in respect of half-year reviews. 210 Most or all of the directors of HIH also attended audit committee meetings, even those who were not members of the audit committee. 211

Meetings between Andersen and HIH management Andersen prepared and distributed presentations to the audit committee in the form of overhead slides. Andersen's presentations to the audit committee were discussed with HIH management prior to audit committee meetings. 212

88 The audit function

Davies gave evidence that the purpose of the meetings included to resolve matters of disagreement between Andersen and HIH management and to enable Andersen to advise HIH management that it intended to communicate any unresolved matters to the audit committee? 13 These purposes were consistent with the proper conduct of an audit.

214 The regular meetings between Andersen and HIH management, and between HIH management and the audit committee215 , stand in contrast to the absence of similar meetings between Andersen and the audit committee in the absence of management. That matter is discussed below.

Meetings between Andersen and non-executive directors on the audit committee The need for meetings It was desirable, even in ordinary circumstances, that Andersen meet non-executive directors, especially those serving on the audit committee, independently of HIH management. A paper entitled 'Arthur Andersen Audit Committees in the 1990s' stated that most committees consist of a majority of 'outside' board members. It speaks of the desirability of auditors meeting privately with the committee in the absence of management. 216 The Cadbury committee recommended that such meetings occur at least annually. 217

Counsel assisting submitted that there was a number of circumstances that increased the need for Andersen to meet the non-executive directors of HIH independently of HIH management.

Pye gave evidence that from August 1999 it was the practice for members of the audit committee to meet HIH management prior to audit committee meetings to discuss agenda items in the absence of Andersen. Pye gave evidence that he became uncomfortable with that approach because he felt that the non-executive directors were forming views before coming to audit committee meetings and before hearing Andersen's position.218 Pye stated that his preference was that HIH adhered to a more conventional corporate governance model with meetings between Andersen and the non-executive directors in the absence of management. Further, Pye stated that HIH directors as a group tended to rely on Williams and HIH management to consider and resolve issues.219

Andersen commented in SMART reports that it was not always certain that non­ executive directors and audit committee members fully understood the significant adjustments to operating results. 220 In those same SMART reports, the 'accounting and financial reporting risk' for HIH was reported as significant or very significant for all the years 1998 to 2001 inclusive. 221

HIH management failed to report to the audit committee David Slee's consistent warning of the desirability of HIH maintaining a solvency margin. Pye gave evidence that reporting on that matter was the responsibility ofHIH management. 222

Davies and Pye gave evidence that they could not recall any occasion when the audit committee preferred Andersen's view to management's opposing view. 223

Th e failure ofHIH Insurance 89

Andersen submitted that it was not Buttle's normal practice to have such communications 'unless the circumstances warranted it'. Andersen submitted that counsel assisting were required to give Buttle an opportunity to comment upon circumstances that counsel assisting considered warranted meetings. In my opinion, such an inquiry was not necessary. The circumstances of the HIH group from at least 1999 warranted meetings between Andersen and the non-executive directors in the absence of management in the ordinary course of the audit. I regard such meetings as a highly desirable and standard audit procedure.

The meeting in March 1999 In the course of the 1999 audit, one meeting was held between Andersen and two non-executive directors. It occurred on 12 March 1999 between Davies, Gooley, Head and Gardener. That meeting, and its consequences, are discussed below. Communications also occurred between Buttle and Cohen in relation to the Pacific Eagle Equities transaction after the 2000 audit had been completed. 224

At the audit committee meeting on 25 February 1999, Andersen raised audit concerns in relation to the extent of several matters, including the deterioration of reserving at a group level, the need for increased corporate governance and the possibility that a qualified opinion would be issued if the proposed presentation of the results to 31 December 1998 was not corrected. 225 Andersen presented a stark depiction of the differences between the HIH group's reported underwriting performance and its underlying performance after one-off adjustments. 226

Davies gave evidence that he was concerned that the audit committee had not fully understood the concerns raised by Andersen at the meeting and accordingly organised to meet Head (then chairman of the audit committee) and Gardener separately?27

Notes of the meeting between Davies, Gooley, Head and Gardener, written by Davies and Gooley, recorded that Head confirmed that the audit committee had fully understood the implications of what had been presented to it. The notes also recorded that the meeting discussed several aspects of the corporate governance of HIH concerning financial reporting matters, including Head's concerns that HIH's results were effectively 'locked in' due to presentations to analysts before audit committee meetings. 228

The fact that the meeting had been held caused disquiet within some quarters of HIH, especially Williams. Williams gave evidence that, although he did not think it was inappropriate for Davies to meet members of the audit committee without first meeting HIH management, he thought that Davies should have told him before the meeting as a matter of courtesy. 229 Williams stated that he wanted to be made aware in advance of any issues or concerns held by Andersen. 23° Fodera gave evidence that he thought Williams was annoyed that Davies had met Head and Gardener without talking to him first and that Williams felt that he had been 'left out of the loop'. 231

Pye232 , Goole/33 and Cohen234 gave evidence that they did not believe that Davies had acted inappropriately in arranging the meeting in the absence of HIH

90 The auditfimction

management, although Cohen thought it was unusual to have done so.235 Davies and Gooley meeting members of the audit committee in the absence of management was consistent with paragraph 12(c) of AUS 710 and paragraph 33 of AUP 32. It was clearly appropriate and desirable for auditors to meet non-executive directors in the absence of management, especially in the circumstances of the HIH group in early

1999, and particularly to deal with the concerns which Davies and Gooley held.

Change of engagement partner Counsel assisting submitted that the 12 March 1999 meeting, and Williams's reaction to it, resulted in Davies' replacement as audit engagement partner. Further, counsel assisting submitted that the combination of Williams ' s reaction to the meeting and Davies' replacement as engagement partner resulted in Andersen thereafter failing to meet audit committee members in the absence of HIH management.

The removal of Davies as engagement partner of the HIH audit team was precipitated by a meeting on 29 April 1999, originally convened for the purpose of conducting a client satisfaction assessment survey, between Knoblanche and Fodera. Notes of the meeting prepared by Knoblanche's assistant recorded that Fodera related to Knoblanche various concerns that Williams had about HIH's relationship with Andersen. In particular, the notes recorded that236 :

• In Williams's eyes, the relationship had gone from being 'one of the very best' to ' absolute rock bottom' and Williams was very upset.

• Williams was concerned that Davies and Gooley had met members of the audit committee without first arranging to meet HIH management.

• Williams did not believe that Andersen was 'bending over backwards' to work through problems.

• HIH management expected Andersen to warn about some of the problems experienced by F AI at the time HIH acquired it.

• Fodera believed that Williams would not be convinced that Davies should continue as engagement partner on the HIH audit.

• Knoblanche went on to discuss the options for replacing Davies as engagement partner.

Davies met Knoblanche after the meeting between Knoblanche and Fodera on 29 April 1999, but before the meeting between Knoblanche and Williams on 3 May 1999. Knoblanche communicated to Davies his decision that there should be a change ofHIH audit engagement partner.237

On 3 May 1999 Knoblanche met Williams. Williams gave evidence that Knoblanche raised the question of replacing Davies as engagement partner. 238 Davies gave evidence that Knoblanche told him after the meeting that Knoblanche had raised the question of his replacement as engagement partner.

239 Knoblanche

denied that he raised the question of replacing Davies, but recalled that there may

Th e failure ofHJH Insurance 91

have been discussion about the 'possible rotation' of Davies .Z40 In light of the evidence of Williams, and the evidence of Davies about his discussions with Knoblanche in relation to the two meetings241 , it is likely that the question of Davies' replacement was discussed at the meeting, even if no conclusions were reached.

At a meeting between Knoblanche and Williams on 15 October 1999, Knoblanche told Williams that it was preferable that Buttle, who had recently joined Andersen242, replace Davies as engagement partner on the HIH audit. 243 On 15 November 1999 Buttle met Williams. Buttle understood that the purpose of the meeting was to allow Williams to decide whether he was comfortable with Buttle becoming the new engagement partner. 244 Buttle subsequently replaced Davies as engagement partner on the HIH audit. 245

Davies246, Buttle247, Pye248, Underwood249 and Williams25 0 each gave evidence of their op inion that the strained relationship between Davies and Williams was a result of the 12 March 1999 meeting and that Williams ' s reaction to the meeting led at least in part to Knoblanche's decision to replace Davies as engagement partner on the HIH audit. Knoblanche25 1 and Underwood252 gave evidence that Davies' style and his promotion within Andersen were factors in the decision to change the engagement partner. Knoblanche stated that a 'triggering event' was that Davies spoke directly to non-executive directors without Williams's prior knowledge. 253

Andersen submitted that, since there was no suggestion that Buttle's independence of HIH was compromised at the time that he replaced Davies as engagement partner, the change of engagement partner cannot be said to have affected Andersen's independence of HIH. I accept that Buttle was independent. There is no suggestion that he was put forward by Andersen because he was likely to be compliant and therefore acceptable to HIH. I do not understand counsel assisting to have submitted that a mere change of engagement partner, without more, compromised Andersen's independence. In any event, the decision to replace Davies as engagement partner was made some months before Buttle agreed to join Andersen.

Andersen submitted that Knoblanche, in his capacity as national managing partner of Andersen and taking into account commercial considerations, properly formed the view that the relationship between Davies and HIH was such that he should be replaced as audit partner. I accept that submission. The issue before me , however, is whether the circumstances of Davies' replacement described above might have affected perceptions of Andersen's independence. For example, did such circumstances send a message to Andersen partners and staff (in particular those serving on the HIH audit) that Andersen personnel who displeased HIH management, for example by meeting non-executive directors, might be removed from the audit. A message of this type might affect the independence of the continuing members of the audit team.

That message may have been sent by Knoblanche's replacement of Davies as engagement partner immediately after learning that Williams was unhappy with Davies.254 Knoblanche acted without reference to the audit team and without any

92 Th e audit function

proper consideration of the cause of Williams's displeasure or its legitimacy. Williams's displeasure arose out of what I consider was an appropriate action for an auditor to take in the circumstances. In my view, Williams's reaction to Davies' meeting was inappropriate. Knoblanche and Andersen should have said so and reacted accordingly when the complaint about the meeting was made. Instead, Knoblanche immediately and unilaterally decided to replace Davies.

Pye understood that Andersen personnel who displeased HIH management might be removed from the audit. Pye gave evidence on at least three separate occasions that HIH management tended to ' shoot the messenger' if they did not like the message. 255 Pye stated that he believed that:

the manner in which [Davies] chose to deliver a message, which was to contact Mr Head directly, had resulted in Mr Williams reacting extremely negatively to Mr Davies.256

In relation to the UK partnership of Andersen, Pye gave evidence that he was concerned that the attitude of the engagement partner, Mark Ward, was 'affecting any message [Andersen] were trying to deliver to HIH about the UK Branch'.257 Pye's concerns culminated in an email to Ward and others in February 2000 in which he complained about the 'constant sniping' of the Andersen UK partnership and its failure to treat HIH with the respect that he considered a client of Andersen deserved. 258 Pye gave evidence that Williams's presence in London necessitated a change in the attitude and approach of Ward, because of the tendency of HIH management to 'shoot the messenger'. 259

Another possible indicator that the 'message' sent by Knoblanche in replacing Davies as engagement partner was received and understood by members of the audit team was the absence of further meetings between Andersen and non-executive directors, save for one instance after the conclusion of the 2000 audit. 260

Although Andersen submitted that communications between Andersen and the non­ executive directors did occur after the meeting in March 1999, these

communications only occurred after the conclusion of the 2000 audit and not in relation to audit matters. As discussed above, I consider that further meetings between Andersen and the non-executive directors in the absence of HIH management were appropriate and necessary.

In my opinion, the circumstances surrounding the replacement of Davies as engagement partner were such that senior members of the Andersen audit team and possibly other Andersen partners and staff and HIH itself were sent the message that Andersen personnel who displeased HIH management, particularly by meeting non­

executive directors, might be removed from the audit. I consider that message might have given rise to the perception that Andersen's independent audit of HIH was or could be compromised.

To determine whether the message also resulted in an adjustment in the behaviour of members of the audit team, such that their actual independence was compromised, it

The failure of HIH insurance 93

is necessary to consider Andersen's audit work and actions in the course of the 1999 and 2000 audits. This is addressed further below.

21.4.5 Non-audit work

Performance of non-audit work Andersen performed at least the following non-audit work for HIH during the 1999 and 2000 audits:

• involvement in the acquisition ofF AI

• involvement in the issue of preference shares by F AI in 2000

• involvement in the Allianz transaction

• involvement in the Winterthur sell-down

• involvement in Project Max

• the secondment of Andersen personnel to HIH, including members of the audit team.

Andersen submitted that the limited nature of the non-audit work performed by Andersen for HIH, particularly when compared to the levels of non-audit work performed by the auditors of similar publicly listed companies at the time, meant that Andersen's actual independence was not affected by its performance of non­ audit work. I accept that submission.

Fee maximisation Counsel assisting submitted that the criteria by which Andersen partners were assessed and rewarded encouraged the generation of fees from non-audit work to the potential detriment of professional obligations such as independence.

That submission arose out of the fact that one of the 'cornerstones' in the evaluation of the performance of Andersen partners and staff was their success in facilitating the use of non-audit services.

In tum, that success depended upon their clients' willingness to engage Andersen to perform non-audit services. In this regard, Pye's ' action plan' for 2000 relevantly stated:

Historically we have had very low success at gaining penetration into the client from other divisions. Essentially all fees are ABA fees driving off our strong, long-standing relationship. Through the SOAR process I hope to identifY a number of opportunities within HIH for other service lines. The key will be to 'partner' them in and manage the relationships and delivery of the product in the 'HIH way' to maximise our opportunities for success. 26 1

One consequence of an auditor exercising appropriate levels of professional scepticism and independence in the course of an audit is that tension may arise in

94 The audit }Unction

the course of the relationship between auditor and client. This was particularly relevant in the case of HIH where, as discussed above, HIH management had demonstrated a tendency to be upset easily. For example, Fodera reported to Knoblanche that Williams felt that the relationship between HIH and Andersen had gone from 'one of the very best' to 'absolute rock bottom' in a very short space of time and largely because of a single meeting. 262

Counsel assisting also submitted that the reduced satisfaction of an audit client as a result of an auditor demonstrating professional scepticism might result in the relevant Andersen partners having difficulty cross-selling Andersen's non-audit services. That difficulty would have adversely affected the auditor's performance evaluation and in tum their remuneration and progression within Andersen.

The potential for a compromise of independence was exacerbated by the fact that the 'cornerstones' by which performance was evaluated at Andersen did not include any express requirement of independence. Andersen witnesses gave evidence that such a requirement was implied.263 Andersen submitted that I should make no finding because 'it was not addressed in the evidence in a comprehensive way and Andersen did not anticipate or address the topic by way of affirmative evidence.' It

is not necessary for me to consider that submission. I make no criticism of Andersen ' s internal procedures for evaluating compliance with independence, except to note that there was no express requirement of independence in the context ofthe performance evaluation of Andersen partners.

Pye denied that he, at any time, thought that he was faced with a conflict between exercising independence and professional scepticism on the one hand, and trying to promote the provision of non-audit services on the other. 264 However, Pye gave evidence that a factor in the extent to which he was likely to have been able to promote the supply of Andersen ' s non-audit services to HIH may have been how

good his relationship was with HIH management.265 Pye also stated that the 'fees assisted' and 'client satisfaction' cornerstones of performance evaluation were linked. Pye's success in the 'fees assisted ' cornerstone would have been affected by his clients' satisfaction with him. 266 Pye considered that the 'client satisfaction' criterion of his performance evaluation would have been one of the factors that affected his future remuneration and ultimately his progression through the partnership. 267 Pye agreed that showing attitudes of independence and professional

scepticism might well make management very unhappy with an auditor. 268 Pye stated that if he was called upon to exercise independence and professional scepticism by resisting management's proposals, that may well have adversely affected his ability to sell or promote the supply of non-audit services to HIH?69

Having regard to the matters described above, I consider that Andersen's performance evaluation process might have given rise to the perception to someone aware of its details that Andersen audit partners would prefer the maintenance of Andersen's relationship with HIH over their professional obligations. I accept that Pye honestly believed that he was not placed in such a position. Andersen submitted

that there was no evidence to suggest that the generation of non-audit fees by audit

The failure of HIH Insurance 95

firms was uncommon at the time and indeed that there was considerable evidence to the contrary. I accept that such arrangements may have been common but that does not determine their appropriateness.

In any event, I am not here concerned with general principles, but with the particular circumstances of the HIH audit which were, in many respects, unusual.

21.4.6 Relationship with overseas offices

Counsel assisting submitted that the correspondence passing between Andersen in Australia and in London indicated that Andersen in Australia demonstrated a 'preference' for preserving its relationship with HIH over its professional obligation to pursue the concerns raised by Andersen in London.

Of particular note was an email from Pye to Gooley, David Caukill, Ward, Garth Hackshall and John Harris (copied to Buttle and Davies) dated 4 February 2000 which reported on a conversation between Buttle, Pye and Fodera in relation to the operations of HIH in the United Kingdom. The email was apparently in response to a number of earlier emails in which Andersen in London raised various concerns about the operations of HIH in the United Kingdom. Pye's email stated that he was disappointed about the 'constant sniping' and attitude of Andersen in London and that he expected Andersen in London to treat HIH with more respect in the future.270

Such an attitude was surprising having regard to Pye's evidence that the matters raised and the courses of action proposed by Andersen in London were proper27 1 and were ultimately justified or correct. 272

I do not consider, however, that the correspondence described by counsel assisting provides sufficient evidence for a finding that the attitude of Andersen in Australia toward Andersen in London demonstrated a lack of independence on the part of Andersen in Australia.

21.4.7 Conclusion

I have concluded that in certain respects the relationship between Andersen and HIH gave rise (or would give rise to those aware of the relevant facts) to a perception that Andersen was not independent of HIH. The circumstances giving rise to that conclusion included:

• the presence ofthree former Andersen partners on the board ofHIH

• HIH' s dealings with the audit committee and non-executive directors, including the consequences of the meeting between Davies, Gooley, Head and Gardener in the absence of HIH management in March 1999

• pressure on Andersen partners to maximise fees from non-audit work, to the potential detriment of their professional obligations.

Andersen submitted that I should not make a finding that there was a lack of perceived independence because the 'question was not addressed in sufficient detail

96 The audit fonction

with all of the relevant Andersen partners and has not been the subject of any expert opinion.' The evidence discussed above satisfies me that the facts upon which my views are based were sufficiently traversed in the evidence. Further, the issue of Andersen's independence was identified by those assisting me as a relevant matter of inquiry since at least the start of the audit phase of the inquiry. Audit

independence, as set out in the relevant auditing standard and code of conduct, necessarily included both actual and perceived independence. I do not consider the issue of audit independence to be one in respect of which I would have been assisted by the opinion of an expert.

I do not consider it appropriate to make findings regarding the effect of Andersen' s relationship with HIH upon Andersen's actual independence without first considering the conduct of the audit by Andersen. An analysis of the way in which Andersen dealt with selected issues in the course of the 1999 and 2000 audits of HIH follows .

21.5 Audit work

In the Commission's investigation of Andersen's audit work, issues arose about the documentation by Andersen of its audit work and audit conclusions and the extent of audit evidence Andersen obtained in the course of its audit work.

21.5.1 Auditing standards

The auditing standards applicable at the time of the 1999 and 2000 audits included AUS 208 'Documentation' and AUS 502 'Audit evidence'. Those auditing standards were summarised in a background paper prepared by those assisting the Commission273 and were the subject of submissions by Andersen.

The mandatory principles and essential procedures on documentation identified in AUS 208 relevant to the Commission's inquiry were:

• The auditor should document matters which are important in providing evidence to support the audit opinion and which evidence that the audit was carried out in accordance with Australian auditing standards. 274

• The auditor should prepare working papers that are sufficiently complete and detailed to provide an understanding of the audit. 275

• The auditor should prepare working papers that record the auditor' s planning; the nature, timing and extent of the audit procedures performed; the results thereof; and the conclusions drawn from the audit evidence obtained. 276

The mandatory principles and essential procedures on audit evidence identified in AUS 502 relevant to the Commission's inquiry were:

• The auditor should obtain sufficient appropriate audit evidence to be able to draw reasonable conclusions on which to base the audit opinion. 277

Th e failure of H/H Insurance 97

• When obtaining audit evidence from tests of control, the auditor should consider the sufficiency and appropriateness of the audit evidence to support the assessed level of control risk. 278

• When obtaining audit evidence from substantive procedures, the auditor should consider the sufficiency and appropriateness of audit evidence from such procedures, together with any evidence from tests of controls to support financial report assertions. 279

• If unable to obtain sufficient appropriate audit evidence, a scope limitation exists, and the auditor should, in accordance with AUS 702 'The audit report on a general purpose financial report', express a qualified opinion. 280

The auditing standards also contained related guidance. In particular, guidance was provided as to ' sufficient appropriate audit evidence' in the following terms:

Sufficiency and appropriateness are interrelated and apply to audit evidence obtained from both tests of control and substantive procedures. Sufficiency is the measure of the quantity of audit evidence; appropriateness is the measure of the quality of audit evidence, its relevance to particular assertions and its reliability. Ordinarily, the auditor finds it necessary to rely on audit evidence that is persuasive rather than conclusive, and will often seek audit evidence from different sources or of a different nature to support the same assertion? 81

As I have explained, any finding that the requirements of these auditing standards were not met does not of itself amount to a finding of a breach of any legal duty and I have made no finding of that type.

21.5.2 Evidence of Couttas

An auditing expert, Couttas, gave evidence on specific audit issues concerning future income tax benefits, deferred acquisition costs, deferred information technology costs, goodwill and going concern. Couttas provided written reports with respect to each of those issues (the Couttas reports).

In October 2001 Andersen received a notice to produce various documents and things including all work papers created in the conduc of the 1999 and 2000 HIH audits which were identified from lists produced by Andersen. That notice was answered and the documents were produced. There was a vast quantity of such documents.

Based upon the documents produced by Andersen, issues papers were prepared by those assisting the Commission concerning the specific audit issues of future income tax benefits, deferred acquisition costs, deferred information technology costs, goodwill and going concern. The issues papers summarised all of the documents which were produced by Andersen or by any other person to the Commission and which those assisting me identified as relevant to the issues addressed in the issues papers.

98 The audit function

The issues papers were provided to Andersen on various dates from May 2002. Andersen was invited to comment upon the papers and to identify any additional documents, audit work or other evidence that had not been identified which it considered relevant to the issues discussed.

With the exception of the paper on future income tax benefits, Andersen delivered written responses to those issues papers. Those written responses identified additional documents which Andersen considered relevant to the issues discussed.

Andersen submitted that it had insufficient time to respond to the issues papers prepared by those assisting and to identify and produce any additional relevant documents. I am satisfied that Andersen had adequate notice of the issues raised in connection with the audit and I do not believe there was any unfairness to Andersen

in the process described above.

For the purpose of preparing his reports, those assisting the Commission provided Couttas with:

• the issues papers and Andersen's responses thereto

• all documents referred to in the issues papers and all additional documents referred to in Andersen's responses.

Couttas was cross-examined by counsel for Andersen. 282

Andersen submitted that all of Couttas's evidence expressing his opinions about the absence of sufficient appropriate audit evidence or audit documentation should be rejected, primarily because Couttas was not provided with a complete set of Andersen's audit work papers for 1999 and 2000. The following exchange occurred

in the cross-examination of Couttas:

Q. And you don't know that you've been given the whole of the relevant documentation, do you?

A. That's correct, I don't know that.

Q. Indeed, as I understand what you say in paragraph 1.3, you don't know whether you've been given a complete copy of Arthur Andersen's audit working papers for either 1999 or 2000, do you?

A. I think what I say in 1.3 is that I've based my opinion on the

papers that were presented to me for the purposes of preparation of this report.

Q. You don't know whether those papers include a complete set of the Arthur Andersen audit work papers for either 1999 or 2000, do you?

A. That's correct.

Q. And unless you have inspected a complete set of the working papers, it would be impossible, as I think you recognise, for you

The failure of HIH Insurance 99

to express a definitive conclusion on the adequacy of the investigations undertaken by Arthur Andersen?

A. I think that's correct, yes.

Q. To try and save time, that's a comment that applies generically [ scil. generally] to each of the reports, isn't it?

A . Yes.

Q. Because in no case, as you understood it, have you seen a

complete set of audit working papers?

A. Correct.

Q. Indeed, you don 't even know whether you've seen a complete set of extracts from the audit working papers that refer to the particular topic of, for example, deferred IT costs, do you?

A. No, that's correct. 283

I do not consider that the fact that Couttas was not provided with a complete set of all audit work papers created in the conduct of the 1999 and 2000 audits means that Couttas's opinions about the sufficiency of audit evidence or documentation on the specific issues he addressed should be rejected out of hand. The process described above did not in my opinion require that Couttas be provided with complete sets of all audit papers for the particular years in order to express his opinions.

This part of the inquiry was not a comprehensive analysis of all Andersen's audit work in the relevant years, but a more narrowly focused inquiry concerning a limited number of specific audit issues raised in the context of the terms of reference. In assessing the weight of the evidence, I have taken into account all relevant considerations, including the difficulties under which all parties have laboured in endeavouring to identify all those documents from the 1999 and 2000 audits which were relevant to the specific issues investigated by the Commission.

It is trite to repeat again that on this, as on all other issues raised, I can only make findings on the basis of the material put before me. Where Andersen identified other documents as relevant to a particular audit issue, those documents were supplied to Couttas. Other documents were put to Couttas in cross-examination by counsel for Andersen. Where no additional documents were identified, I have proceeded on the basis that Couttas had seen all of the documents relevant to the particular issue that were then known to exist.

To the limited extent that additional documents were raised with Couttas in the course of his cross-examination, I have considered those documents, Couttas's evidence about them and all submissions made concerning them. Later, additional material was identified in both counsel assistings' and Andersen's submissions that had not been considered by Couttas. I have also taken that material into account in making my findings, which I stress again are not the findings of a court following a trial at law in which the legal rules of evidence apply.

100 The auditfonclion

If the audit issues addressed in this chapter need to be revisited at a later date, or for other purposes, and additional material is located or becomes available, then my findings would have to be reconsidered in light of that additional material. That is true not only of the audit issues, but all other issues addressed in the course of this

mqmry.

21.5.3 Audit issues

In the course of the Commission, those assisting conducted a detailed analysis of certain key issues arising in the 1999 and 2000 audits.

The specific issues discussed in this chapter are the following:

• Andersen' s audit work with respect to the appropriateness of the recognition of future income tax benefits attributable to timing differences and tax losses as assets of HIH as at 30 June 1999 and 30 June 2000 and, in particular, whether those future income tax benefits met the specific recognition criteria prescribed by the accounting standards.

• Andersen' s audit work with respect to the appropriateness of the amount of deferred information technology costs recognised as assets of HIH as at 30 June 1999 and 30 June 2000.

• Andersen's audit work with respect to the appropriateness of the recognition of deferred acquisition costs as assets of HIH as at 30 June 1999 ($278.3 million) and 30 June 2000 ($304.3 million).

• With respect to the goodwill recognised on the acquisition of F AI as at 30 June 1999 ($275 million) and as at 30 June 2000 ($438 million), Andersen' s audit work as to the manner in which the amount of goodwill was determined as at 30 June 1999 and 30 June 2000 and the assessment of the carrying value of that goodwill.

• Andersen's assessment of the appropriateness of the adoption of the going concern basis of accounting in the general purpose financial reports of HIH for the eighteen months ended 30 June 1999 and the year ending 30 June 2000.

Aspects of Andersen's audit work in respect of provisioning, reinsurance, the F AI preference share issue, pledged assets and netting-off are discussed elsewhere in this report.

The audit issues addressed in this and other chapters of the report do not represent a comprehensive list of matters arising in the conduct of the 1999 and 2000 audits. They were topics identified by the Commission as being of particular relevance to the financial reports of HIH. This selection of key issues was a necessary process having regard to the time, resources and jurisdictional constraints under which my

inquiry was conducted.

The f ailure of HIH Insurance 101

21.5.4 Future income tax benefits

Future income tax benefits (FITB) are the estimated amount of future savings in income tax likely to arise as a result of the reversal of timing differences and the recoupment (or both) of carried forward tax losses? 84

AASB 1020 'Accounting for income tax (tax-effect accounting)' prescribed that:

• FITB attributable to timing differences should be carried forward as an asset only where realisation of the benefit could be regarded as being assured beyond any reasonable doubt. 285

• In the case of companies which incurred tax losses, FITB could not be recognised as an asset unless realisation of the benefits was virtually certain, irrespective of whether the FITB arose from tax losses or timing differences?86 ASIC Practice Note 36 (PN 36) stated that the virtual certainty test required an extremely high level of probability (only marginally less than absolute certainty) that the FITB would be realised287 , and provided guidance for determining whether the test had been satisfied. 288

• In drawing up consolidated accounts, FITB brought to account by one company in a group of companies can not be offset against a provision for deferred income tax brought to account by another company in the group. 289

In the 30 June 1999 financial report, an amount of $145.2 million was recorded in respect of FITB for timing differences and $27.2 million for tax losses. In the 30 June 2000 financial report, the amount recorded in respect of FITB for timing differences was $91.2 million and for tax losses was $137.2 million. 290 Neither financial report disclosed a provision for tax or for deferred income tax.

In 1999, Andersen was provided with a spreadsheet prepared by Paul Abela (and emailed to Fodera on 29 September 1999). The spreadsheet recorded that:

• The FITB balance attributable to tax losses disclosed in the 30 June 1999 financial report for the HIH consolidated entity ($27.2 million) was a net figure which had been arrived at by offsetting the consolidated entity's provision for deferred income tax ($113.6 million) against the consolidated entity's gross balance ofFITB attributable to tax losses ($140.8 million).

• The FITB balance attributable to timing differences disclosed in the 30 June 1999 financial report for the HIH consolidated entity ($145.2 million) was a net figure which had been arrived at by offsetting the consolidated entity ' s provision for income tax ($60.0 million) against the consolidated entity's gross balance of FITB attributable to timing differences ($205.2 million).291

No documents similar to the Abela spreadsheet were located in respect of the FITB balances disclosed in the 30 June 2000 financial report. By reference to documents contained in the Andersen audit work papers292 Couttas estimated293 that the FITB

102 Th e auditfimction

balances disclosed m the 30 June 2000 financial report were determined m the following manner:

• The FITB balance attributable to tax losses disclosed in the 30 June 2000 financial report for the HIH consolidated entity ($137.2 million) was a net figure which had been arrived at by offsetting the consolidated entity ' s provision for deferred income tax ($131.3 million) and a portion of the consolidated entity's provision for income tax ($40.6 million) against the consolidated entity' s gross balance of FITB attributable to tax losses ($309.1 million).

• The FITB balance attributable to timing differences disclosed in the 30 June 2000 financial report for the HIH consolidated entity ($91.2 million) was a net figure which had been arrived at by offsetting a portion of the consolidated entity's provision for income tax ($56.1 million) against the consolidated entity' s gross balance of FITB attributable to timing differences ($147 .3 million).

The 30 June 2000 financial report disclosed that the directors had forecast that FITB in relation to tax losses would be recovered over a period of up to five years. 294

The issues raised in respect of Andersen ' s audit work in the 1999 and 2000 audits in relation to FITB upon which submissions were made were:

• Whether the manner in which the balances of provision for deferred income tax were offset against FITB attributable to tax losses as at 30 June 1999 and 30 June 2000 was a contravention of AASB 1020 and, if so, whether Andersen ought to have qualified its audit report in that respect. AASB 1020 relevantly stated:

A future income tax benefit brought to account by one company in a group of companies shall not be offset against a provision for deferred income tax brought to account by another company in the group of companies, when drawing up group accounts.295

• Whether the manner in which the balance of the provision for income tax was offset against the balance of FITB attributable to timing differences as at 30 June 1999 and 30 June 2000 was an inappropriate accounting treatment and if so, whether Andersen ought to have qualified its audit report in that respect.

• The extent to which Andersen obtained sufficient appropriate audit evidence with respect to the recognition of FITB as an asset as at 30 June 1999 and 30 June 2000.

The failure of HIH Insurance 103

Recognition of FITB as an asset

Th e 1999 audit The audit work papers created in the conduct of the 1999 audit by Andersen with respect to taxation were directed to the risk associated with taxation calculations. The audit work papers did not deal with the risk ofFITB not being recoverable.296

Based upon the material presented to him, Couttas expressed the opinion th at Andersen should have, but failed to, obtain sufficient audit evidence and specialist assistance in order to assess adequately whether there was virtual certainty regarding the realisation of FITB on a group or company basis in the conduct of the 1999 audit. In Couttas's opinion, in those circumstances Andersen should have issued a qualified audit opinion. 297

With respect to the 1999 audit Pye gave evidence that he believed that HIH was going to make future profits, such that prior period losses would be recoverable. This belief was formed as part of his general conclusion as to going concern. Pye stated that he believed that the cause of the losses had ceased because a large proportion of the difference between reserves booked in December 1997 and June 1999 related to FAI and were not ongoing operational problems that would continue to generate losses. 298 An assessment in those terms by Pye was not documented in the 1999 audit work papers.

In any event, Andersen's submissions about goodwill and going concern make it clear that Andersen did not review current projections of future performance in the conduct of the 1999 audit.

Davies gave evidence that he assessed the recoverability ofFITB on the basis that in 1999 HIH reported a small loss, but only after bringing to account an abnormal item and an extraordinary item of $50 million each. So, HIH' s operating results indicated that it was operating profitably. 299 An assessment in those terms by Davies was not documented in the 1999 audit work papers.

Andersen submitted that what was sufficient appropriate audit evidence was a matter for the auditor's judgment and that the effect of the submissions by counsel assisting was to replace Andersen ' s judgment with the judgment of counsel assisting or Couttas. Neither counsel assisting, nor Couttas had experience from previous audits ofHIH. They were applying the benefit of hindsight.

In considering the audit work it would be inappropriate simply to substitute, with the benefit of hindsight, a judgment as to what would have been a preferable conclusion for the judgment that was formed by the auditor at the time. I have not done so. I have made my findings on the basis of a review of the evidence seen in the light of the requirements of professional standards which applied to the conduct of the audit at the time. Where that review has compelled a different conclusion from that formed by Andersen, I have found accordingly.

An assessment of the appropriateness of the recognition of FITB as an asset of HIH group compames was clearly required having regard to the relevant accounting

104 Th e audit fonction

standard (AASB 1 020) which prescribed specific tests for the recognition of FITB and the guidance available in PN 36. This was particularly so in light of the losses incurred to 30 June 1999.300 It is clear that such an assessment was not undertaken by Andersen, accepting the evidence of Pye and Davies as to the actual assessments of the recoverability ofFITB undertaken in the 1999 audit explained above.

I consider, in the light of the above, that Andersen did not obtain sufficient appropriate audit evidence with respect to the recognition of FITB as an asset of HIH group companies as at 30 June 1999, as was required by AUS 502. Without such evidence Andersen should not have accepted either the setting off of provisions for tax and deferred tax against FITB, or the recognition of the net amounts of FITB as assets.

In Chapter 20 I have also concluded, for reasons which I there give, that none of the net amount of FITB recognised as an asset of the HIH group of companies as at 30 June 1999 should have been recognised.

The 2000 audit In the conduct of the 2000 audit, Andersen performed audit work in relation to the recognition of FITB and, in doing so, concluded that there was a residual audit risk in that respect. 30 1

This assessment was consistent with a number of audit work papers and memoranda prepared in August, September and October 2000 which documented that audit procedures were to be specifically directed to the recoverability of FITB.302 The recognition of FITB in the 30 June 2000 financial report was a significant issue throughout the 2000 audit. 303

A review conducted by the Andersen tax division expressly disclaimed any assessment of the recoverability ofFITB.304

The recoverability of FITB was raised as an issue at the audit committee meetings on 12 September 2000305 and 12 October 2000.306 At the meeting on

12 October 2000, it was resolved that the financial report would disclose the expected recovery period for tax losses (five years). 307

The management representation letter for the 2000 audit dated 16 October 2000, provided to Andersen and signed by Williams, Cassidy and Fodera, stated:

The directors are virtually certain that all future income tax benefits relating to tax losses included in the financial report will be recovered in a period of not more than 5 years. 308

Andersen's audit conclusion that the recognition of FITB as at 30 June 2000 was appropriate was primarily based upon309 :

• Three memoranda, prepared by Abela at Buttle's requese'o and reviewed by Fodera, in respect of tax losses incurred in Australia, the United Kingdom and the United States. 311 The memoranda were signed and dated 17 October 2000, although drafts dated 16 October 20003 12 were provided to Pye before being

Th e failure of HIH Insurance 105

reviewed by Fodera.313 The memoranda set out certain assumptions made by Abela and ways in which tax losses were expected to be recouped. Pye sought and received the views of Andersen in the United Kingdom as to the ability of HIH to realise tax losses in that jurisdiction.314 For the purpose of the US memorandum, it appears that Andersen relied on documents prepared by Steven Posner (of Andersen in the United States) in relation to St Moritz. 315

• A budget presentation made by Fodera in October 2000.

The three Abela memoranda were written management representations. There is no evidence that Andersen sought to corroborate these representations as required by AUS 520. 3 16

With respect to the three Abela memoranda, Couttas gave evidence thae 17 :

• The Australian and the UK memoranda did not contain sufficient appropriate audit evidence as to whether there was virtual certainty of realisation of FITB in respect of income tax losses recorded by Australian companies in the HIH group and income tax losses recorded by the UK branch of HIH, and they did not consider the realisation ofFITB in respect of timing differences. In particular:

106

a detailed analysis, on a company-by-company basis, of FITB relating to income tax losses was a pre-requisite to a proper evaluation of the ability of the Australian companies to realise the benefit of the tax losses. It does not appear that analysis was undertaken31 8

the estimate of future earnings for the 'F AI side' of the HIH group was based upon broad unsubstantiated assumptions, which was inconsistent with the guidance in PN 36 319

where future earnings were anticipated to be derived in consequence of the Allianz transaction, the existence of conditions precedent to that transaction meant that there was no virtual certainty that the transaction would be completed320

there was no evidence that Andersen considered the impact of the Allianz transaction on the ability of companies in the HIH group to satisfy the ' same business test' and hence their ability to realise the FITB in respect of tax losses321

the Australian and UK memoranda did not adequately consider the criteria which PN 36 required to be assessed322

the UK memorandum made reference to the 'possibility' of recouping certain losses which clearly did not meet the standard of virtual certainty.323

The audit function

• The US memorandum did not represent sufficient appropriate audit evidence as to whether realisation of FITB in respect of income tax losses recorded for HIH's Californian workers compensation businesses of $21 603 921 was virtually certain. Couttas also noted that the US memorandum did not consider the realisation of FITB in respect of timing differences.

Abela submitted that HIH, with the assistance of tax specialists from Andersen, spent considerable time considering the impact of the Allianz transaction and that the structure adopted to conduct the joint-venture activities was 'clear testament to the parties' attempts to satisfy the various elements of the same business test' 324

[emphasis added]. Abela further submitted that he, with the assistance of the Sydney, Chicago and New York offices of Andersen, analysed the ability to set off tax losses generated by HIH's Californian workers compensation operations against taxable gains to be derived from the St Moritz subgroup of companies. But there is no evidence demonstrating that these matters were resolved to the level of virtual certainty required by AASB 1020.

The existence of the deficiencies, risks and uncertamtles identified by Couttas shows that the Australian, UK and US memoranda could not represent sufficient appropriate audit evidence that of the realisation of FITB in respect of income tax losses recorded by HIH group companies in the three jurisdictions was virtually ce1iain. Further, the Australian, UK and US memoranda dealt only with FITB arising from tax losses. Those memoranda did not consider the likelihood of realisation of FITB in respect of timing differences. The test of virtual certainty applied to all FITB balances of HIH group companies where they incurred tax losses.

A memorandum to the files from Pye titled 'HIH review of 2001 budget' was prepared in respect of the 2001 budget presentation made by Fodera. 325 The memorandum concluded as follows:

Based on the attached analysis the significant improvements in profitability are achievable provided the insurance cycle remains in an upward swing (ie. improving premium rates and a fewer catastrophic events than in recent years as HIH do not have prudential margins to absorb this). Strong commitment is also needed by management to

restructure unprofitable operations and [to] reduce costs as the group shrinks in size.

The results may also be affected by adverse developments in some of [the] open exposures as has occurred this year ( eg. in many of the F AI areas currently in run-off). Refer to a separate memo on our conclusions on th e exposures.

However, based upon the attached it is considered that HIH will make sufficient returns in key jurisdictions to support the carrying value of goodwill and tax losses with one exception, goodwill on the Californian operations. A separate analysis will be performed on this. A separate paper will also deal with the technical aspects of the recoverability of the tax

losses (ie whether they are groupable against future profits, etc.) ... 326

Th e failure of HIH Insurance 107

A memorandum to the files dated 4 April 2001 prepared by Pye in respect of the assessment of the going concern assumption also referred to the presentation by Fodera and stated:

... our final conclusion was that the forecasts would be difficult to achieve given HIH's historical performance and weaknesses in the budgeting process documented in our management letter ... 327

The uncertainties highlighted in these memoranda evidence serious doubts about HIH's ability to achieve the forecasts set out in Fodera's presentation. On this basis, the onerous requirement of virtual certainty could not have been met.

Other documents created by Andersen at or about the time of completion of the 2000 audit raised concerns as to HIH's ability to achieve income and cash flow forecasts and limitations of the budgetary process. 328 Those concerns substantially undermined any conclusion of virtual certainty based upon forecast financial information. -

In summary, Couttas expressed the opinion that Andersen failed to obtain sufficient appropriate audit evidence to satisfy itself regarding the virtual certainty test and should have issued a qualified audit opinion. In particular, Couttas considered that Andersen did not give adequate consideration or obtain specialist assistance in relation to the realisation of FITB (including that attributable to timing differences), the factors listed in PN 36 or the impact of the Allianz transaction. 329

In respect of the 2000 audit, Andersen submitted that what was sufficient appropriate audit evidence was a matter for the auditor's judgment and that the effect of the submissions by counsel assisting was to replace Andersen's judgment with the judgment of counsel assisting or Couttas, neither of whom had experience from previous audits of HIH and each of whom has the benefit of hindsight. I have already explained the way that I have approached the evidence in the light of this

submission.

The audit evidence obtained by Andersen in the conduct of the 2000 audit could not, in my view, support the recognition of FITB as at 30 June 2000 having regard to the onerous criteria set out in AASB 1020. It follows, in my opinion, that Andersen did not obtain sufficient appropriate audit evidence with respect to the recognition of FITB as an asset of HIH group companies as at 30 June 2000 as was required by AUS 502.

Buttle, the engagement partner, gave evidence that the test that he applied in assessing virtual certainty in the conduct of the 2000 audit was whether there were reasonable grounds to believe that HIH would continue to operate profitably in the future. 330 This is a less stringent test than that required by AASB 1020. Buttle's misapprehension as to the correct test may explain the deficiencies in the audit evidence noted above.

108 The audit function

Offset of income tax balances

Background With respect to the offset of income tax balances described above, Couttas gave evidence that331 :

• Analysis available on a company-by-company basis established that provisions for deferred income tax totalling $32.5 million and $69.0 million were able to be offset validly against FITB attributable to tax losses as at 30 June 1999 and 30 June 2000 respectively.

• Provision for deferred income tax provision of $81.5 million as at 30 June 1999 and $62.3 million as at 30 June 2000 remained which, in the absence of appropriate audit evidence, should not have been offset against the balance of FITB attributable to tax losses.

• To the extent that FITB in respect of income tax losses was offset against the provision for deferred income tax on a combined HIH and F AI group basis, that accounting treatment contravened AASB 1020. There was no evidence that Andersen had raised that matter as a concern.

• To the extent that FITB attributable to timing differences of $60 million as at 30 June 1999 and $40.5 million as at 30 June 2000 was offset against the provision for income tax, this was an inappropriate accounting treatment because realisation of the FITB would only occur in future periods, whereas the provision for income tax was a current liability which could not be reduced by

the reversal of timing differences in the future. There was no evidence that Andersen had raised that matter as a concern.

• The Andersen audit work papers maintained in respect of the 1999 audit did not include any documented consideration of the appropriateness of the manner in which provisions for deferred income tax and for income tax were offset against FITB attributable to both timing differences and tax losses.

• In the conduct of the 2000 audit, Andersen was aware that the offsets that took place in respect of income tax balances at 30 June 1999 were undertaken again as at 30 June 2000. The Andersen audit work papers did not include any documented consideration of the appropriateness of those offsets. 332

Offset of provision for deferred income tax against FITE attributable to tax losses With respect to the offset of the provision for deferred income tax against FITB attributable to tax losses:

• Abela gave evidence that there were spreadsheets available which provided detail of income tax balances on a company-by-company basis. 333 Abela also made submissions to this effect. Abela gave evidence that he did not think that the manner in which the income tax balances were determined in respect of the consolidated financial report was ever on a company-by-company basis. 334

The failure of HIH Insurance 109

• Pye gave evidence that it was his understanding that the amounts shown on the spreadsheet involved the aggregation of available FITB due to timing differences and tax losses after an analysis of deferred income tax liabilities as a result of that analysis being carried out at a company-by-company level.

335

Pye's recollection was that the bulk of the timing differences and tax losses were in the operating companies, such that if the offset calculations were done on an individual company basis and then aggregated, this would result in the same income tax balances as when the consolidated tax balances were offset.

336

• The company level spreadsheets referred to by Pye and Abela have not been located by those assisting the Commission in either company records or the audit work papers. There is no reference to such spreadsheets in the audit work papers and there are no audit work papers evidencing that the spreadsheets were reviewed in the course of the 1999 or 2000 audits.

Andersen submitted that in the absence of a review and analysis of the company level spreadsheets referred to by Pye and Abela, no adverse findings should be made.

Andersen also submitted that in the absence of the company level spreadsheets it is not possible to determine whether the result of offsetting FITB in respect of income tax losses against the provision for deferred income tax on a combined HIH and F AI group basis would be materially different to the balance of FITB in respect of income tax losses that would be determined if a company-by-company analysis of income tax balances were undertaken.

The audit evidence obtained by Andersen in the 1999 33 7 and 200033 8 audits strongly suggested that FITB in respect of income tax losses was offset against the provision for deferred income tax on a combined HIH and F AI group basis. That accounting treatment represented a prima facie breach of AASB 1020. In those circumstances, Andersen was required to obtain sufficient appropriate audit evidence to establish that there was in fact no breach. In my opinion, Andersen did not perform sufficient audit work to establish that this was so.

It follows that Andersen did not obtain sufficient appropriate audit evidence with respect to income tax balances (specifically FITB attributable to tax losses and provision for deferred income tax) disclosed in the 1999 and 2000 financial reports as was required by AUS 502.

Offset of provision for income tax against FITB attributable to timing differences Abela has drawn attention to items recorded on the spreadsheet prepared by him 339 in respect of the offset of the provision for deferred income tax against FITB attributable to timing differences which stated 'most of the provision for income tax is found in the HIH consolidation companies and amounts to a recapture of previous FITB (timing) balances'. Abela elaborated upon that passage in his submissions.

Andersen also made submissions as to this item, which incorporated references to Abela's submissions.

110 The auditfimction

The passage referred to by Abela was not directly considered by Couttas in his report, nor was it directly put to him in cross-examination. The matters raised for the first time in submissions by Andersen and Abela are technical in nature and, in the absence of expert evidence, I make no findings in respect of them.

It follows from what I have found that in my view Andersen should not have accepted either the setting off of provisions for tax and deferred tax against FITB, or the recognition of the net balances as assets in the group accounts at 30 June 2000.

In Chapter 20 I have found, for the reasons I there give, that none of the net amount ofFITB recognised as an asset in those accounts should have been recognised.

21.5.5 Deferred acquisition costs

Acquisition costs are incurred in obtaining and recording policies of insurance. They include commission or brokerage paid to agents or brokers for obtaining business for the insurer, selling and underwriting costs such as advertising and risk assessment, the administrative costs of recording policy information and premium collection costs.

AASB 1023 'Financial reporting of general insurance activities' required thae40 :

• Acquisition costs incurred in obtaining and recording policies of insurance be deferred and recognised as assets where they can be reliably measured and it is probable that they will give rise to premium revenue that will be recognised in subsequent financial years.

• Acquisition costs leading to future benefits be recognised as assets and amortised over the financial years expected to benefit from the expenditure.

• Assets only be recognised where it is probable that the future economic benefits will eventuate and the asset can be measured reliably.

• Deferred acquisition costs be amortised systematically over the financial years expected to benefit.

• When the recoverable amount of deferred acquisition costs is below cost, they be written down to their recoverable amount and the write-down be recognised as an expense.

AASB 1023 provided that the recoverable amount of deferred acquisition costs would be below cost where the sum of the deferred acquisition costs and the present value of both expected future claims and settlement costs, in relation to business written to the reporting date, exceeded related unearned premiums.

341

In the 30 June 1999 and 30 June 2000 financial reports of HIH, amounts of $278.3 million and $304.3 million respectively were recognised as assets in respect of deferred acquisition costs. 342 The financial reports also disclosed HIH's accounting policy in respect of acquisition costs. 343

Th e failure ofHJH Insurance 111

HIH recognised both direct and indirect acquisition costs as assets. Direct acquisition costs included such items as brokerage. Indirect acquisition costs recognised as assets by HIH included 80 per cent of various staff costs, premises costs, travel expenses, entertainment, professional fees, promotion and information technology costs. 344

Calculation of deferred acquisition costs Audit work papers prepared by Andersen in the course of the 31 December 1997 audit evidence that Andersen conducted an examination of the methodology by which HIH calculated the amount of deferred acquisition costs to be recognised as assets at each relevant balance date. 345 The calculation methodology was revisited by Andersen in the conduct of the 1999 and 2000 audits so as to establish that there had been no significant change in that methodology. 346

Recoverable amount of deferred acquisition costs The issue raised in respect of Andersen's audit work in the 1999 and 2000 audits in relation to deferred acquisition costs upon which submissions were made was the extent to which Andersen obtained sufficient appropriate audit evidence as to the recoverable amount of deferred acquisition costs.

Did HIH assess the recoverable amount of deferred acquisition costs? Fodera gave evidence of his understanding that the assessment of the recoverable amount of deferred acquisition costs in the terms set out in AASB 1023 was a calculation performed by the HIH accounting division quarterly, six monthly and yearly. 347 Fodera thought that Cubbin and Howard did the calculation. 348 However, Fodera could not recall being provided with a deferred acquisition costs calculation nor did he check whether any calculation had been carried out. 349 Fodera suggested that because every HIH insurance division was forecasting profits, HIH complied with the deferred acquisition costs calculation. 350

Howard gave evidence that Cubbin did the calculation for the assessment of the recoverable amount for deferred acquisition costs and that Howard did not. 351

Cubbin gave evidence that he never performed a 'recovery test' (that is, an assessment of the recoverable amount) at HIH in respect of the balance of deferred acquisition costs as at 30 June 1999 and 30 June 2000 and that no one from Andersen ever told him that he needed to perform such a test. 352 Cub bin stated that he only became aware of the necessity for such a test when he subsequently came to be employed by Allianz. 353

Cubbin said that he understood that the person responsible for considering the recoverability of deferred acquisition costs was 'probably Jeff Simpson'. 354 However, Cubbin also stated that the topic of a recoverability test never arose in discussions with Simpson as to Cubbin's methodology for calculating deferred acquisition costs. 355 Simpson resigned in mid-July 1999. 356

112 The audit function

Pye gave evidence that his understanding was that someone within the financial services division of HIH performed a recoverability test. The inference that he drew from the audit work papers was that it was Cub bin. 357

The following control as to deferred acquisition costs was noted in a risk control document as a part of Andersen's identification of controls and evaluation of the design of controls in the course of the 1999 audit.

The DAC test is performed at year end to ensure that the recoverable based upon the budgeted ULR and the balance in unearned premmm [sic ].358

The control was stated to have been confirmed as being in operation as at 16 August 1999. The means by which this confirmation arose was not documented in the audit work papers.

Audit work paper BPR-20, obtained by Andersen in the conduct of the 2000 audit, consisted of a document entitled 'deferred acquisition costs-discussion paper' dated 22 August 2000, prepared by Cubbin (financial controller of accounting operations), with various spreadsheets attached. 359 The paper stated the following objectives:

1. Examination of the relevant accounting standards and corporate accounting policies surrounding the issue of deferred acguisition costs and including direct and indirect acquisition costs.

2. Provision of details on the method of quantifying those costs and the deferral methodology and parameters.

3. The adjusted balances for 30 June 2000 are then detailed and compared against peers in the Insurance Sector. 360

The paper included the following passage from AAS 26 (AAS 26 was the equivalent Australian Accounting Standard to AASB I 023):

For an asset to be recognised, it must be probable that the future economic benefits will eventuate and that it possesses a cost or other value that can be measured reliably ... 361

The paper concluded:

Summary

As can be seen the calculations produce a combined DAC balance, which is $30M higher than the levels booked in the General Ledger. Given the potential changes to the organisation and in particular the likely divestment of some of the operations it was considered prudent not to book any further DAC in the General Ledger.

An exercise has also been conducted to benchmark the HIH level of DAC to that of a peer in the insurance industry. For the purpose of this exercise QBE was selected and a review of their financial statements shows that

their DAC percentage as a proportion ofNEP is consistent with HIH.

The failure ofHIH Insurance 113

It is therefore considered that the deferred acquisition cost of $304.3M is stated and a true and fair value. 362

The audit work papers maintained in respect of the 1999 and 2000 audits do not make reference to HIH management other than Cubbin.

On the basis of the evidence of Fodera, Howard and Pye and the audit work papers cited above, Andersen submitted that the HIH group's methodology included a recoverability test and in particular, that the recoverability test was applied as at 30 June 1999 and 30 June 2000.

Further, Andersen submitted that, to the extent that it was necessary to determine who did the recoverability test, it was one or more of Cub bin, Simpson and Howard with respect to the balance at 30 June 1999, Cubbin and Howard with respect to the balance at 30 June 2000, or alternatively, in both years by unidentified members of HIH's financial services division. Andersen suggested that Cubbin may have performed calculations as a part of a process which ultimately included a recoverability assessment, without him apprehending it at the time.

The evidence shows that Fodera and Howard understood that Cubbin undertook the recoverability assessment. Cubbin's evidence, which was credible and which I accept, was that he was not aware of the requirement for such an assessment whilst he worked at HIH. Cubbin's suggestion of Simpson's possible involvement was speculative. In any event, I note that Simpson had left HIH in July 1999, prior to the

1999 audit. I am therefore satisfied that HIH did not undertake a recoverability assessment as at 30 June 1999 or 30 June 2000.

Audit work performed by Andersen The Andersen audit work papers maintained in respect of the 1999 and 2000 audits do not include:

• any recoverability assessment performed by HIH with respect to deferred acquisition costs

• any commentary or review by Andersen of any recoverability assessment performed by HIH.

On the basis of the documents presented to him, Couttas expressed the opinion that there was no evidence that Andersen had considered the recoverable value of deferred acquisition costs determined in accordance with the requirements of AASB 1023 by reference to the present value of both expected future claims and settlement costs (in relation to business written to the reporting date) and the related unearned

. 363

premmms.

Andersen submitted that in both the HIH group audits for the periods ending 30 June 1999 and 30 June 2000 it was open to it to make, and it did make, the professional audit judgment that the recoverability of deferred acquisition costs for· the HIH group in aggregate as at the respective balance dates did not give rise to a material audit risk in all of the circumstances. It was submitted that Andersen

114 Th e audit function

identified, amongst other things, that the HIH consolidated entity had historically made substantial operating profits before tax and abnormals both prior to the period ended 30 June 1999 (for example, $90.6 million, $113.9 million and $55.32 million in the years ended 31 December 1996, 1997 and 1998 respectively), in the period ended 30 June 1999 ($74.3 million) and the year ending 30 June 2000 ($61.9 million). Andersen submitted these were reliable indicators that deferred acquisition costs had been consistently recovered in the past.

The reasoning process leading to those conclusions is not documented anywhere in the audit work papers maintained in the conduct of the 1999 or 2000 audits.

Andersen's submissions accepted that no audit work was done in the conduct of the 1999 and 2000 audits with respect to the recoverability of deferred acquisition costs. Andersen submitted that this was appropriate as a matter of professional judgment having regard, amongst other things, to HIH's historical profitability. As to this submission, I note the following:

• AASB 1023 sets out a specific test for the assessment of the recoverability of deferred acquisition costs. That test was not premised upon historical profitability.

• HIH did not perform the specified recoverability assessment of deferred acquisition costs as at 30 June 1999 or 30 June 2000.

• AUS 502 required that, when obtaining audit evidence from substantive procedures, the auditor should consider the sufficiency and appropriateness of audit evidence from such procedures, together with any evidence from tests of control to support financial report assertions. 364 One of those financial report assertions required to be supported was that an asset or liability was recorded at an appropriate carrying value.365

It follows , in my opinion, that Andersen did not obtain sufficient appropriate audit evidence concerning the assessment of the recoverable amount of deferred acquisition costs as at 30 June 1999 or 30 June 2000 as required by AUS 502.

21.5.6 Deferred information technology costs

Included as assets in the 30 June 1999 and 30 June 2000 financ ial reports of HIH were amounts representing expenditure in respect of computer development projects (deferred IT costs). There were no specific disclosures with respect to that item in the financial reports.

There was no accounting standard or professional pronouncement which directly considered the recognition of expenditure in respect of computer development projects as assets at the time of the conduct of the 1999 and 2000 audits.

Statement of Accounting Concepts 4 'Definition and recognition of the elements of financial statements' (SAC 4) defines assets as future economic benefits controlled by the entity as a result of past transactions or other past events, and states that an

Th e failure of HIH Insurance 115

asset should be recognised in a statement of financial position only when it is probable that the future economic benefits embodied in the asset will eventuate and the asset possesses a cost or other value that can be measured reliably. 366

SAC 4 is not an accounting standard. The primary purpose of SAC 4 is expressed to be as a guide to the Australian Accounting Standards Board and the Public Sector Accounting Standards Board in developing and reviewing accounting standards and other authoritative documents, and it may also provide guidance in analysing new or emerging issues in the absence of applicable accounting standards.367

Andersen audit work papers recorded that amounts of $30 million, $63 million and $88 million were recognised as assets in HIH's accounts as at December 1998, June 1999 and June 2000 respectively in respect of deferred IT costs. 368

The issues raised in respect of Andersen 's audit work in the 1999 and 2000 audits in relation to deferred IT costs upon which submissions were made were:

• the extent to which Andersen obtained sufficient appropriate audit evidence with respect to the composition of the balance of deferred IT costs recognised as an asset as at 30 June 1999

• the extent to which Andersen obtained sufficient appropriate audit evidence with respect to the carrying value of deferred IT costs as at 30 June 1999 and 30 June 2000

• in not requiring HIH to make an adjustment of $11.7 million (or $8.6 million), whether the 2000 financial report was materially misstated.

Background Audit work papers, prepared by Andersen in the course of the 31 December 1997 audit, evidence that Andersen documented policies and processes by which amounts representing expenditure in respect of computer development projects were

. d 369 recogmse as assets. The work papers prepared by Andersen in the course of the 30 June 1998 and 31 December 1998 reviews evidence further consideration of the amounts recognised as assets in respect of deferred IT costs. 370 The work papers record that the future impact upon profitability of amortisation of the deferred IT costs was discussed at the audit committee meeting on 25 February 1999,371

Cubbin gave evidence that he had discussions with Andersen in relation to deferred IT costs for the purposes of the 30 June 1999 and 30 June 2000 accounts. He stated that these discussions would normally have been with junior Andersen staff who examined HIH's back-up papers, including time sheets from Artemis, pro forma journals from IT and other relevant papers. Any questions in relation to the actual

systems or technical IT questions were referred directly to the IT managers. Cubbin · gave evidence that Andersen always requested and examined information supporting the expenditure that had been capitalised. 372

116 Th e audit f unction

The 1999 audit

Background Amounts recognised as assets in respect of deferred IT costs increased from $30 million as at 31 December 1998 to $63 million as at 30 June 1999. 373

Andersen audit work papers record that the future impact of the amortisation of deferred IT costs upon profitability was discussed at the audit committee meeting on 25 August 1999. 374

A memorandum to the files dated 10 September 1999 prepared by Pye stated:

The audit committee papers contained a paper summarising the deferred costs booked on the balance sheet. We have satisfied ourselves that based upon current projections of future performance that these costs are recoverable. 375

Andersen submitted that in this extract Pye was referring to both deferred IT costs and to goodwill. 376

The composition of the balance of deferred information technology costs recognised as an asset as at 3 0 June 1999 Andersen submitted that it was open for it to make, and it did make, a proper professional judgment as to the amount and nature of audit work which was reasonably required to be undertaken in relation to the balance of deferred IT costs as at 30 June 1999, including:

• continuing discussions with Cub bin and others in the IT department of HIH, as appropriate

• continuing review of relevant supporting documentation, as appropriate.

Andersen submitted that its judgment as to what was sufficient and appropriate was properly made in the context of:

• Andersen's professional judgment that there was a low inherent risk of material financial misstatement at both the financial report and account balance levels

• prior satisfactory testing of the HIH group's deferred IT costs policies and procedures and other risk control processes

• Andersen's own analyses and actions (including back-up papers) for the proper capture and capitalisation of deferred IT costs in the 31 December 1997 audit and in the 30 June 1998 and 31 December 1998 audit reviews

• a fairly recent (31 December 1997) positive conclusion that HIH's deferred IT cost capitalisation method used for major projects was appropriate

• prior discussions with and the 'experiences' of Cubbin and other members of the HIH group's IT department.

The failure of HIH Insurance 117

Andersen submitted that it was entitled to and did:

• conclude that there was no material risk of material misstatement of the HIH group's deferred IT costs balance as at 30 June 1999

• focus upon what it considered to be the real business risk as at 30 June 1999, being the expected effect of the deferred IT costs balance on future HIH group earnings

• take appropriate steps to ensure that this concern was brought to the attention of both HIH management and the audit committee.

It is noteworthy that the only evidence cited by Andersen to support the submissions as to the relevant audit work on deferred IT costs actually performed in the course of the 1999 audit is the evidence of Cub bin referred to above. 377 There is no reference made by Andersen to any audit work papers.

I do not think Andersen should have been satisfied that there was a low inherent risk of material financial misstatement with respect to deferred IT costs in circumstances where the balance of deferred IT costs recognised as an asset increased by more than 100 per cent in the six months between 31 December 1998 and 30 June 1999. In any event, such a conclusion was not documented in the 1999 audit work papers.

Based upon the material presented to him, Couttas gave evidence that the audit procedures undertaken by Andersen to ensure that expenditure capitalised as deferred IT costs during the 18 months ended 30 June 1999 satisfied the definition of an asset under Australian Accounting Standards were deficient in that they did not include adequate procedures to corroborate management explanations. 378

As Australian auditing standards note, in general, an oral representation from an internal management source is the least reliable form of audit evidence.379

AUS 520 'Management representations' provided that the auditor should obtain written representations from management on specific matters material to the audit report, when other sufficient appropriate audit evidence cannot reasonably be expected to exist. 38° Further guidance was provided in AUS 520 as follows:

• Representations by management cannot be a substitute for other audit evidence that the auditor could reasonably expect to be available. 381

• During the course of an audit, management makes many representations to the auditor. When such representations relate to matters which are material to the financial report, the auditor will need to:

118

seek corroborative audit evidence from sources inside and outside the entity

evaluate whether the representations made by management appear reasonable and consistent with other audit evidence obtained, including other representations

The audit function

consider whether the individuals making the representations can be expected to be well-informed on the particular matters?82

Andersen's submissions concerning the corroboration of management representations made only passing reference to AUS 520. Andersen's submissions appear to suggest that the requirement to corroborate arose only where there was concern as to a lack of honesty, reliability or competence of the person making the representation. AUS 520 makes it clear that the requirement to corroborate is not so limited, but applies to any matter which is material in the context of the financial report as a whole.

Andersen submitted that there was independent corroboration of oral statements made by individual HIH group personnel to Andersen regarding the HIH group's policies and procedures in relation to deferred IT costs, including via discussions with Cubbin, members of the HIH group's IT department and more senior management. To the extent this was the case, it was not documented in the audit work papers and no other evidence was adduced by Andersen. Further, there was no evidence that Andersen reviewed documentation in respect of HIH's policies and procedures.

Andersen's submissions in respect of the audit work undertaken on the composition of the balance of deferred IT costs recognised as an asset as at 30 June 1999 cite and rely upon both audit work and audit conclusions which are not sufficiently documented to make them credible. It follows that Andersen did not obtain sufficient appropriate audit evidence with respect to the composition of the balance of deferred IT costs recognised as an asset as at 30 June 1999 as required by AUS 502.

Recoverable amount of deferred information technology costs as at 30 June 1999 Based upon the material presented to him, Couttas gave evidence that there was no evidence as to what audit procedures Andersen undertook in respect of future cash flows when assessing the recoverable amount of deferred IT costs recorded as assets in HIH' s 1999 financial report. 383

Andersen submitted that there was clear, uncontradicted, contemporaneous evidence that in the course of the 1999 audit it considered current projections of future performance in reaching a positive conclusion that the HIH group ' s deferred IT costs balance as at 30 June 1999 was recoverable and that Andersen documented that conclusion. The basis for this submission was the memorandum to the files dated 10 September 1999 prepared by Pye384 set out above.

Further, Andersen submitted that it was not put to Pye that the memorandum to the files dated 10 September 1999 was false in any respect, that Andersen did not satisfy itself as to the recoverability of deferred IT costs as at 30 June 1999 as the memorandum records, or that Andersen did not do so based on a consideration of current projections of future performance as the memorandum records. These matters were not put to Pye.

Th e failure of HIH Insurance 119

On the other hand the following matters must be considered:

• Pye's conclusion that work was done as to the recoverability of 'deferred costs booked on the balance sheet' is not supported by reference to underlying audi t work papers. This is surprising having regard to the requirements of AUS 208 discussed above.

• The Pye memorandum states that Andersen was satisfied as to recoverability 'based on current projections of future performance'. Andersen's submissions in respect of goodwill and going concern make it clear that such projections were not reviewed in the conduct of the 1999 audit.

Having regard to the above, in my opinion, the Pye memorandum does not explain how Andersen audited the carrying value of deferred IT costs recognised as an asset as at 30 June 1999.

As no other basis for this conclusion has been put forward, in my opinion Andersen did not obtain sufficient appropriate audit evidence with respect to the carrying value of deferred IT costs recognised as an asset as at 30 June 1999 as required by AUS 502.

The 2000 audit Background Amounts recognised as assets in respect of deferred IT costs increased from $63 million as at 30 June 1999 to $88 million as at 30 June 2000. 385

In the conduct of the 2000 audit, Andersen recorded that amounts totalling $26 million in respect of deferred IT costs had been recognised as assets in the last quarter of the year ending 30 June 2000. 386 Andersen also expressed concern as to HIH's policy with respect to the recording of deferred IT costs. 387 These matters were identified by Andersen as requiring further audit consideration.

Audit work papers388 support Cubbin's evidence389 that supporting documentation with respect to deferred IT costs was examined by Andersen staff in the conduct of the 30 June 2000 audit.

In the conduct of Andersen's audit work, an amount of $11.7 million was identified. The composition of the $11.7 million was described in the following terms in the audit work papers:

120

[per discussions with] Doug Cubbin and Domonic Maceri (Financial Accountant-Accounting Operations) these costs relate to information processing performed by the divisions due to system failures. The contractor costs/salaries/rent allocations have been determined by each division. These costs relate to processing only and not IT development ie there are no IT Technical people costs included in these numbers. Information processing relates to backlogs generated by system down time, reprocessing due to data corruption and additional financial assistance to reconcile financial information. 390

The auditfonction

Andersen initially recorded their view that the amount of $11.7 million should be expensed in the profit and loss account. 391

This initial view was revised following the Allianz transaction and the costs were not expensed. 392 A memorandum to Andersen's files dated 17 November 2000 prepared by Henderson listed proposed adjusting journal entries arising in the course of the 2000 audit, including an adjustment of $11.7 million in respect of deferred IT costs. 393 In respect of the proposed adjustment of $11.7 million the annotation 'effectively sold' appears. 394 Andersen confirmed that the handwritten notation 'effectively sold' referred to the amount of the IT costs being recovered as a result of the Allianz transaction. 395

Andersen also recorded initial concerns with respect to the recoverable amount of HIH's deferred IT costs as at 30 June 2000. 396 The audit work papers record that these concerns were allayed following HIH's entry into the Allianz transaction.397

The final draft of the management letter sent by Andersen to Fodera under cover of a letter dated 2 November 2000 recorded Andersen's observation that no clear recognition criteria had been established with respect to deferred IT costs, together with Andersen's suggestions in that regard. 398

Recoverable amount of deferred information technology costs as at 30 June 2000 Counsel assisting submitted that Andersen did not obtain sufficient appropriate audit evidence in respect of the carrying value of deferred IT costs as at 30 June 2000 as required by AUS 502.

Andersen submitted that there was clear, uncontradicted, contemporaneous evidence that, in reaching a positive conclusion that the HIH group's deferred IT costs balance as at 30 June 2000 was recoverable, it considered projections of the HIH group's future performance and the effect of the Allianz transaction.

Andersen also submitted that the competing submissions referred to above were no more than a difference of opinion as to a complex, judgmental audit matter as to which Andersen were, and counsel assisting were not, qualified to express an opmwn.

Three documents were identified in Andersen's response to the going concern issues paper399 which were relevant to a consideration of Andersen's audit work with respect to the recoverable amount of deferred IT costs as at 30 June 2000.400 These documents were not identified in the deferred IT costs issues paper, nor in Andersen' s response to that paper. As a consequence, these documents were not considered by Couttas. The documents were not put to Couttas's in cross­ examination.

There is no evidence available to me to identify the impact that these additional documents may have had upon the opinions expressed in Couttas's report. On this basis, I make no adverse findings as to Andersen's audit work in respect of the carrying value of deferred IT costs as at 30 June 2000.

Th e failure of HIH Insurance 121

$11 .7 million adjustment Couttas expressed the opinion that $11.7 million was inappropriately recognised as an asset as part of deferred IT costs. This was because such costs would ordinarily be considered operating costs of the period in which they were incurred since they would be unlikely to enhance the economic value of the underlying information technology system. They would therefore not meet the definition or recognition criteria for an asset. 401

The amount of $11.7 million was part of a total of $26.7 million of deferred IT costs less an amount of $15 million, which was explained in the following terms in the audit work papers:

Doug's deferral relates to listing of IT related invoices amounting to $18.1 m. Doug Cubbin (Financial Controller- Accounting Operations) estimated that $I 5m was capitalisable. AA reviewed invoices and capitalisation policlo (work performed by A Haston-TRC). See IT capitalisation RCD. 02

Andersen submitted that the relevant amount ought to have been $8.6 million. This figure derives from the total of $26.7 million less an amount of $18.1 million which was explained in the following terms in the audit work papers:

.. . An analysis of the IT program cost summary report was then conducted which showed that an additional $I 8.1 M could have been deferred using the previous methodology. This analysis was then checked by the IT accountant who confirmed the amounts identified. A copy of the amount by application and activity is attached ... 403

It is unnecessary to decide which residual amount was correct (that is, $11.7 million or $8.6 million). Both amounts were material, being 21 and 15 per cent respectively of the reported operating profit before income tax of the HIH consolidated entity for the year ending 30 June 2000.404

Andersen submitted that it was open to it to conclude, it reasonably concluded and it was the case that the inclusion of that amount did not create a substantial doubt that the HIH group's deferred IT costs balance was materially in error or the HIH 2000 financial report was materially misstated such as to require a qualification by Andersen of their audit report. This submission was made on the basis that it was an exercise by Andersen of its professional judgment in the circumstances then existing and notwithstanding the identification of an amount which arguably (but not certainly) ought not have been deferred. The circumstances referred to were:

• the existence of a further $3.1 million of IT costs which the HIH group was properly entitled to defer

• senior management's 'strong' representations that there were other deferrable IT costs that had not been deferred

• the Allianz transaction, which was considered to provide evidence of the recoverability of the deferred IT costs balance taken as a whole.

122 Th e audit function

Further, Andersen submitted that the contrary view by Couttas simply represented a disagreement between professionals in respect of a complex matter of judgment.

Andersen's submissions fail to have due regard to the materiality of the relevant amount (whether it was $11.7 million or $8.6 million) and that the initial recording of the amounts as assets was inappropriate for the reasons given by Couttas. If there were 'strong' management representations that the relevant amount included other deferrable IT costs that had not been deferred, those representations were not documented in the audit work papers. Nor were they corroborated as was required by AUS 520. In my opinion, no cogent explanation was advanced as to why the adjustment was not made.

Evidence of Coultas Andersen submitted that reliance upon Couttas's evidence was 'unsafe' due to what were said to be 'various qualifications, errors, misleading and/or unexplained statements, overstated conclusions and the withdrawal and modification of key findings'.

As a general proposition, Couttas's evidence has been accepted. No adverse findings were sought by counsel assisting, and none have been made, in respect of individual matters on which Couttas made concessions. Those concessions do not detract from the evidence obtained in respect of the substantive issues considered above.

21.5.7 Accounting for goodwill

Goodwill prior to the acquisition ofF AI For the financial year ending 31 December 1996, goodwill was recorded in the financial records of HIH at $48.8 million. 405 By 31 December 1997, goodwill had increased to $67.2 million406 and by 31 December 1998 to $104.1 million. 407

AASB 1013: 'Accounting for goodwill' The principles to be applied in the recognition of goodwill on the acquisition of an entity or part' thereof were stated in AASB 1013, which relevantly and in summary provided:

• Goodwill means the future benefits from unidentifiable assets. 408

• Goodwill which is purchased by the entity must be recognised as a non-current . . . 409

asset at acqms1tlon.

• Goodwill is only recognised as an asset when it is probable that the future benefits embodied in the unidentifiable assets will eventuate and it possesses a cost or other value that can be measured reliably. 410

• The unamortised balance of goodwill must be reviewed at each reporting date and recognised as an expense in the profit and loss account to the extent that future benefits are no longer probable.411

The failure ofHIH Insurance 123

• Purchased goodwill must not be revalued. 412

In relation to the measurement of goodwill on the acquisition of an entity or part thereof, AASB 1013 relevantly and in summary provi ded:

• On acquisition, the identifiable net assets of the entity acquired must be measured at their fair values. 413

• Goodwill must be measured as the excess of the cost of acquisition incurred by the entity over the fair value of the identifiable net assets acquired. 414

• To the extent that the cost of acquisition incurred by the entity exceeds the fair value of the identifiable net assets acquired but the difference does not constitute goodwill, such difference must be recognised immediately as an expense in the profit and loss account. 415

• Where it becomes known, subsequent to acquisition, that assets or liabilities existed at the date of acquisition but were not recognised, an adjustment must be made in respect of those assets and liabilities and, where relevant, in respect of the amount of goodwill or discount on acquisition. A similar adjustment must also be made where assets and liabilities which were unidentifiable at acquisition subsequently become identifiable. 41 6

Goodwill on acquisition ofFAl by HIH For accounting purposes, HIH treated its takeover of FAI as having occurred on 1 January 1999. HIH calculated the total cost of acquisition to be $300.5 million. 417 Goodwill in respect of the F AI acquisition was recorded in the general ledger at 30 June 1999 at $274 997 956. 418

A paper entitled 'FAI acquisition' 41 9 prepared by HIH management set out a calculation of goodwill on acquisition of $275 million on the basis of a cost of acquisition of $300 million and adjusted net assets at acquisition of $25 million. Net assets at acquisition were derived by making a number of adjustments to the $224 million reported net assets of F AI as at 30 June 1998. A summary of the adjustments set out in the paper is as follows:

• $67 million reduction in net assets, being in respect of FAI's trading loss for the six months ended 31 December 1998

• $20 million reduction in net assets, being for redundancy costs and representing 'the expected total payout for 400 F AI and HIH staff retrenched as part of the merger process'

• $35 million reduction in net assets, being for computer write-offs/other expenses on the basis that it was 'necessary to recognise a significant write­ down of computer related assets and associated IT costs' with other costs said to include 'dead rent, relocation, staff transition and training programs'

124 The audit function

• $7 4 million reduction in net assets relating to 'claims reserves'. This item resulted from a '[r]eview of claims reserves subsequent to December 1998' which 'identified a further deterioration' in the workers compensation, professional indemnity/public liability, inwards and Queensland CTP portfolios

• $12 million reduction in net assets relating to ' Hannover'

• $20 million reduction in net assets relating to the GCR and NI reinsurance contracts

• $23 million reduction in net assets described as 'actuarial adjustment'

• $40 million reduction in net assets in respect of 'reinsurance exposures'

• $20 million reduction in net assets relating to the fair value at acquisition of Oceanic Coal

• $112 million increase in net assets, being the income tax effect of the above items.

The 'F AI acquisition' paper also set out the following:

The make up of the adjustments to net assets may vary as the extent of the claim reserves deterioration and value of strategic assets becomes more certain. It may even be necessary to further increase the goodwill in the next financial year.

The amount of goodwill generated by the adjustments to net assets is certainly at the higher end of expectations. It is however considered necessary and appropriate to properly recognise the extent of the adjustments so as not to adversely impact the future results of the insurance activities of the Group. 420

A paper entitled 'FAI goodwill carrying value' 421 , also prepared by HIH

management, set out the following with respect to the carrying value of the goodwill on acquisition ofF AI:

During the year HIH purchased the operations of F AI Insurances through an on market offer. Total consideration was approximately $300m. The strategic reasons for purchasing F AI were two fold ; it provided HIH with critical mass in the Australian market which has been consolidating rapidly (through such mergers as NRMA/SGIO and AMP/GIO), and it strengthened HIH's presence in key markets of personal lines and CTP. F AI had established strong brand awareness for its personal lines, a telephone sales operation, F AI Direct, to sell its products, a distribution channel HIH was yet to fully develop.

FAI's other lines of business included similar lines of commercial insurance already underwritten by HIH. These lines of business have no real strategic value to HIH other than the F AI acquisition eliminated a competitor from the market. These lines of business are being absorbed

into HIH's existing divisions where an extensive review was conducted and a cull of unwanted business made to bring this business to a minimum break even position. A similar plan is being executed for the overseas

The failure ofHJH Insurance 125

126

operations that are being integrated into existing HIH operations where possible, or assessed for closure where this is not possible. For the purposes of assessing goodwill carrying value no strategic value is attached to these operations.

In addition to the insurance operations F AI included a number of assets HIH deemed non-core, these included a coal operation, an interest in a life insurance company, a financial planning group and various other financing companies. The investment book also included large equity positions in various companies, which fell outside HIH investment strategy. Since acquisition HIH has embarked on a program to sell these assets. At 30 June some assets remain on the books and book values have been adjusted to what management believe is a reasonable market value.

In addition to the asset sales and revaluations, HIH conducted a comprehensive review of the claims book across all lines of business. Some lines of business were found to be under reserved based upon HIH 's experience and others have shown extensive deterioration during fiscal

1 999. HIH has brought the reserves up to what management believes is a minimum acceptable reserving position. HIH also purchased a stop loss policy to cover any potential further deterioration of the HIH and FAI books (the Hannover policy).

The total purchase consideration for the F AI Group, after including acquisition costs was $300m. After the asset write downs, restructuring costs, reserve strengthening and the purchase of reinsurance protection goodwill now stands at $275m. For HIH to be able to justify the carrying value of the goodwill, the two strategic businesses, F AI Direct and CTP must produce sufficient returns to support the carrying value of the goodwill. HIH management believes this is achievable due to a lower cost structure, represented through savings in reinsurance costs due to the purchasing power of the combined HIH/F AI book and the lower overhead structure of a larger group.

A review of the budgets for 2000 indicate the following core earnings, including associated investment earnings, (i.e. FAI's contribution to the overhead pool):

- CTP Queensland -CTPNSW* - Reinsurance and other savings for Group - FAI Direct -Net return before tax - After tax

$12 469 000 7 000 000 40 000 000 ($274 000) 59 195 000 37 885 000

Using an earnings multiple of 12 (based on the average PE multiple for HIH), this produces a value for FAI to HIH of $455 million.

The annual amortisation charge for the FAI goodwill is $13.7 million, which is significantly less than the estimated profitability for the year. The estimate of profitability is conservative as it excludes any capital growth of the investment portfolio funded from the insurance revenues.

Th e audit fonction

On the basis of the above analysis there is reasonable evidence to support the recoverability of the FAI goodwill.

*Assumes one third of CTP NSW is former FAI business and hence one third of forecast profit has been assumed in this calculation.

The budgeted figures adopted in the ' FAI Goodwill Carrying Value ' paper422 were contained in the budget presentation to the board on 2 June 1999. 423

In the course of the year ending 30 June 2000, several adjustments were made to the calculation of net assets of F AI at acquisition such that the amount of goodwill at cost recognised with respect to the acquisition ofF AI increased from $27 5 million at 30 June 1999 to $438 million at 30 June 2000.424 This calculation implied that FAI had a deficiency of net assets of $138 million at acquisition.

A paper entitled ' Goodwill on FAI acquisition'425 prepared by HIH management set out a summary of the adjustments as follows:

• $137.1 million reduction in net assets relating to 'Pre-acq underwriting losses' which consisted of the discontinued F AI professional indemnity and public liability lines of business and Lloyd's syndicate 1236, which went into run-off in August 1999

• $63 million reduction in net assets relating to ' Future GCR/NI premiums '

• $40 million reduction in net assets described as 'general reserve'. The general reserve had been taken up for any additional F AI pre-acquisition liabilities that had not been currently recognised

• $77.3 million increase in net assets, being the income tax effect of the above items.

At the audit committee meeting on 12 September 2000, Andersen presented a summary of the audit issues for the financial year ending 30 June 2000. 426 The presentation highlighted the carrying value of goodwill and noted that the goodwill had increased from $346 million as at June 1999 to $475 million (prior to amortisation charge) and that FAI represented $438 million of this .427 Andersen noted that the impact of the proposed Allianz joint venture was as follows 428 :

Value to HIH $400m ($200m cash, $200 investment of N)

Split as follows :

$m Residual goodwill

Goodwill - F AI 321

- CIC 9 FAI (NZ & WC)

Deferred IT 30 Cotesworth

FITB 10 Other

Other 30

400

The failure of HIH Insurance

$m 84 22 27

133

127

Fodera's presentation to Andersen on or about 5 October 2000 identified that goodwill would be reduced by $330 million in consequence of the Allianz transaction. 429

Carrying value of remaining goodwill A paper prepared by HIH management entitled 'Goodwill FAI post joint venture' 430

assessed the carrying value of goodwill in the light of the Allianz transaction. The paper set out the following:

This paper sets out the FAI Goodwill position as at 30 June 2000 and the potential effect of the Joint Venture. The goodwill on the remaining FAT business is then reassessed.

Goodwill as at 30 June 2000 - FAI - HIH America - Great States

Initial take up of JV offset against goodwill

Balance of goodwill post JV

$'000

405 265 20 235 3 715

330 000

99 215

Remaining goodwill can be allocated as follows :

2000 Result/ Est % of 2001 FAI

Division Budget Business

Workers Compensation 15 480 50%

New Zealand 12 982 20%

Property 7 814 20%

Professional Indemnity 17 939 10%

IRS 1 247 50%

Total Future earnings based on June 2000 Actual Result

Insuranc e Result Multiple 7

7

7

7

7

Goodwill 54 180 18 175 10 940

12 557 4 365 100 216

In conclusion, the remaining FAI goodwill is justifiable based on the potential earnings of the remaining F AI businesses

US goodwill The minutes of a meeting of the audit committee held on 12 September 2000 recorded:

128

Mr Fodera tabled an analysis of the goodwill account ($133.2 million) after the Allianz transaction. There was discussion as to whether the goodwi ll associated with the purchase of the US operations should be written off. It was concluded that the US goodwill figure could be substantiated on budgeted future profits, especially once claims inflation reduced to more normal levels. Amongst other options, a sale of the US operations was being contemplated. However no firm commitment had

Th e audit function

been made as any decision would be dependent on current market conditions. 431

On 12 October 2000 a meeting of the HIH audit committee was held. Following the meeting Pye prepared a memorandum to the files. 432 The memorandum made the following comments in respect of US goodwill:

We advised the Committee that we had identified a number of material adjustments and had used the general reserve of $40m to absorb the adjustments. Hence no general provisions now exist. We also advised that we had also offset a write down in US goodwill of $20m against a further write up of the F AI goodwill as we could find no support for the carrying value of the US goodwill.433

The 1999 audit Adjustments made in determining net assets ofF AI at acquisition As is explained above, in calculating the net assets of F AI upon acquisition, a number of adjustments were made to the reported net assets of F AI as at

30 June 1998. 434 The first was a downwards adjustment of $67 million in respect of a trading loss to 31 December 1998. Some attention was paid to this adjustment during the hearings because on 5 March 1999, Peiris provided Fodera with a balance sheet and profit and loss statement for F AI Insurances Limited and its controlled entities as at 31 December 1998, which was said to be final, and which disclosed a $47 million trading loss, not a $67 million trading loss. 435 In his initial goodwill calculations prepared in April 1999, Simpson used figures which were consistent with the accounts prepared by Peiris in calculating retained earnings of 31 December 1998 , and then made a further adjustment of $20 million for

redundancy and restructure. 436 An adjustment for redundancy costs of $20 million was also allowed for in the paper entitled 'FAI acquisition' .437 No evidence was given which explained how the statements of trading loss in the paper and in the accounts could be reconciled. There was evidence, which I accept, that Andersen verified the trading loss to the generalledger.438 Andersen was not provided with a copy of the financial statements for F AI for the stx months ended

31 December 1998. 439 Those financial statements would themselves have been prepared from the generalledger.440

Although counsel assisting submitted that, prima facie, there was an error either through double counting or through manipulation of the ledger, counsel assisting did not submit that Andersen was at fault in accepting the figure of $67 million as the trading loss to 31 December 1998, nor that any adverse finding be made against any individual in respect of this matter. The Commission was not able to resolve the apparent inconsistency.

Counsel assisting submitted Andersen did not obtain sufficient appropriate audit evidence with respect to the adjustments made to net assets ofF AI at acquisition for redundancy costs ($20 million) and computer write-offs and other expenses ($35 million). This was primarily based upon a submission that there was no documented consideration of the requirements of Urgent Issues Group Abstract 8

The failure ofHIH Insurance 129

'Accounting for acqutsitJons-recogmtwn of restructuring costs as liabilities ' (UIG 8). UIG 8 set out that it was unlikely that a liability for restructuring costs would arise as at the date of acquisition unless certain conditions were met. Counsel assisting's submissions were supported by evidence from Couttas. 441

Andersen submitted that there was evidence that the requirements of UIG 8 were complied with. This evidence was said to be contained in the Part A statement issued by HIH Investment Holdings Limited in relation to the offer to acquire F AI shares. 442 The disclosures in the Part A statement were not considered by Couttas in his report and were not put to him in cross-examination.

I have considered the evidence referred to by Andersen. I accept that the disclosures provide a possible basis by which the requirements of UIG 8 may have been satisfied. There is no evidence before me to suggest that the disclosures could not provide such a basis. I do not propose to make any adverse findings in respect of the adjustments made to net assets ofF AI at acquisition in respect of redundancy costs ($20 million) and computer write-offs and other expenses ($35 million).

The paper entitled 'FAI acquisition' 443 set out four further adjustments to PAl's insurance reserves as at 31 December 1998 resulting in downwards adjustments to net assets of $129 million as at 31 December 1998. $74 million of the adjustments related to the deterioration of claims incurred prior to 31 December 1998. There was no issue before me about those adjustments.

There was a further adjustment of $12 million described simply as 'Hannover'. There was some dispute regarding that figure. Andersen submitted that this adjustment was identified in an audit work paper as 'pre-acq[uisition] goodwill' and as agreeing to the reinsurance working papers. Andersen submitted that it was part of the larger consideration of the accounting for the Hannover contract and referred to Pye's evidence that he believed that it was linked to a further adjustment that was made to goodwill of$40 million for 'reinsurance exposures'.

In Section 16.2.7 I have set out and adopted counsel assisting's summary of the accounting entries which were made in the financial statements as at 30 June 1999 in respect of the Hannover transaction. There were two debits to goodwill (ie. increases to goodwill) booked in relation to the Hannover transaction. The first was in respect of a liability of $40 million which was booked not to F AI General Insurance Co Limited, but to a notional consolidated entity. I have criticised the fact that the $40 million liability to reinsurers was credited not to F AI, but to the consolidation company or entity. If the liability had been credited to F AI, there would be no objection to there being a corresponding debit to goodwill provided that the carrying value of goodwill could be justified. The vice, it seems to me, in the accounting for that item lies in the entity against which the liability was credited. I here use the word 'entity' loosely because some of the HIH consolidation

'companies' were not legal entities at all but simply accounting devices.

The second entry related to the amount of $11.3 million. At 30 June 1999 the Hannover transaction was accounted for by reductions in the provisions for

130 The auditfonction

outstanding claims in HIH C&G and F AI General of $400 million before discount. The smaller the discount the larger the reduction in the provision for claims. The amount of the discount for HIH C&G and FAI General totalled $155 million. However, in the consolidation company there was a reversal of this discount of $11.3 million and that amount was debited to goodwill. That entry caused an $11.3 million accretion to profit for the period ending 30 June 1999.

Slee calculated the discounted value of the recoveries under Hannover 1 as being $255.014 million. The schedule of reserves shows that the recovery which was booked (more accurately, the liability reduced) at 30 June 1999 totalled $244 million, a difference of $11 million. 444 Clearly the amount debited to goodwill represented the difference between the discounting as calculated by Slee and the discounting of the liabilities taken off of the balance sheet of HIH C&G and F AI General.

Both Fodera and Pye acknowledged that it would not be proper to book to goodwill the difference in the discount as determined by the company and the actuary.445

In my opinion there was no proper basis for this adjustment.

That is not to say that there could not have been an adjustment to goodwill for more than the amount of $40 million representing part of the liability to reinsurers. Indeed, I would have thought that more than $51.3 million could have been so booked, provided its carrying value could be justified.

A further item of adjustment to the net assets of F AI at 31 December 1998 was an adjustment of $20 million in respect of 'GCR/NI'.

I am satisfied, as Andersen submitted, that this amount represented the difference between the premium due by 30 June 1999 of $35.550 million under both the GCR AXOL and NI contracts and the amount actually booked in the general ledger at 31 December 1998 of$15.434 million. I am satisfied also that this amount does not include any amount in respect of the GCR 6 contracts. 446 Although both the GCR AXOL and NI contracts had prospective elements, and in particular the NI contract covered PAl's discounted loss ratio for the entire 12 months to 30 June 1999, that is both before and after acquisition date, I think that it is clear that in substance the premium required to be expensed at 30 June 1999 related to reinsurance cover for the deterioration of pre 31 December 1998 claims. That was certainly the case in relation to the GCR AXOL contract. To the extent that it may not have been the case in relation to the NI contract, I think the difference is likely to be minimal.

The third matter of adjustment which was the subject of dispute was the amount of $23 million described as an 'actuarial adjustment' . It was submitted by Andersen that the adjustment may have been an adjustment to PAl's pre-acquisition reserves and was therefore an appropriate adjustment to the net assets of F AI as at 31 December 1998. The discussion paper prepared by management on the goodwill calculation made a separate adjustment for the deterioration of the claims reserves as at 31 December 1998 of $74 million. That was in respect of the workers

The failure of H/H Insurance 131

compensation, professional indemnity/public liability, inwards and Queensland CTP portfolios.447 The 'actuarial adjustment' of $23 million was something in addition to that.

The nature of the adjustment appears, I think, from an Andersen working paper which contains the following handwritten note upon an email dealing with the expected future development of the P AI reserves. The note reads:

$23m variance to actuary

Final Actuarial Assessment

HIH Booked

Difference

Prudential Margin Booked

Unexplained di fference

$2,698 .8 @ 25/8/99

$2 ,674.0 @ 19/8/99

24.8

23 .0

1.8

$23m booked to g/will as pre-acqn deterioration in reserves. Has not been specifically attributed to individual COB's. T&A to actuarial summary as HIH booked amount. 448

The schedule of group reserves which was checked by Andersen449, included an amount of $23 million as 'prudential margin (con sol)' . 45 0 As Andersen noted in the passage I have quoted, the amount which had been booked to goodwill had not been attributed to an individual line of business. Rather, it represented the difference between the provisions which were made for all of the portfolios and the actuary' s assessment of net reserves for the entire group of $2 698.8 million. It plainly did not qualify as a permitted adjustment. I am surprised that it was passed. If there were additional known reserve deteriorations in P AI, they should have been booked in P AI. The effect of the course adopted was to increase improperly the reported consolidated operating profit before tax by $23 million. This was a material amount.

Counsel assisting made no submissions that adverse findings were required in respect of the adjustments made to net assets of P AI at acquisition relating to the fair value at acquisition of Oceanic Coal ($20 million). I accept this position.

The principal question in relation to the amount of goodwill booked at 30 June 1999 was not the adjustments which were made, but the assessment of the carrying value of the goodwill. I say this because it is clear to me that if adequate provision had been made for PAl's pre-31 December 1998 claims at 30 June 1999, and ifthe GCR and NI contracts had been properly accounted for, the adjustments to PAl's net assets as at 31 December 1998 would have far exceeded the $199 million of adjustments (net of tax benefits) which were made.

Assessment of the carrying value of goodwill as at 30 June 1999 Andersen's assessment of the carrying value of goodwill attributable to the acquisition of PAl as at 30 June 1999 comprised a review of the paper prepared by _ HIH management entitled 'PAI goodwill carrying value' 45 1 set out above.

132 Th e audit fonction

The 'FAI goodwill carrying value' paper sought to justify the recoverability of the goodwill on acquisition of F AI by reference to the budgeted core earnings (including associated investment earnings) of selected businesses ofF AI. 452

With respect to this, Couttas gave evidence that453 :

• From the documentation reviewed by him, no work appeared to have been undertaken by Andersen to assess the reasonableness and feasibility of those budgeted figures.

• No allowance appeared to have been made in the budgeted core earnings (including associated investment earnings) for F AI overhead costs. It would not have been appropriate to ignore these costs in assessing the carrying value of the goodwill by reference to the 2000 year budgeted core earnings (including associated investment earnings). Couttas did not know, one way or the other, whether the F AI overhead costs were brought to account in determining core earnings.454

• The budgeted earnings for certain of the F AI lines of business would have to support all of the other net assets associated with these lines of business, as well as FAI's corporate net assets (excluding goodwill). No consideration appeared to have been given to the extent of the net assets (excluding goodwill) associated with these F AI lines of business as well as the F AI corporate net assets and the impact that this would have on the assessment of the carrying value of goodwill on the acquisition ofF AI.

• A significant component of the budgeted before tax profit used to justify the carrying value of the goodwill ($40 million of $59.2 million) related to 'reinsurance and other savings for the group' . There was no evidence of any procedures undertaken by Andersen to assess the reasonableness and feasibility

of these anticipated costs savings.

With respect to these matters, Andersen submitted:

• No assessment was required of the budgeted results ofF AI in the context of the 1999 audit because:

the integration of the F AI personal lines gave HIH a superior distribution platform

significant action had already been taken by HIH to integrate the F AI businesses, including retrenchments and culling of unwanted businesses.

• These two matters rendered any budgeted profit forecasts uncertain and so a detailed analysis would have been of minimal utility. As it was, HIH was considering the profitability of the parts of the businesses that had driven the acquisition just six months prior.

The failure of HIH Insurance 133

• HIH subsequently derived a goodwill figure of $275 million. The budgeted profits of the core businesses that had driven the acquisition ($37.9 million) indicated that profits were likely to be significantly in excess of the futu re amortisation charge of $13.7 million that would result from booking that goodwill amount.

• The budgeted profitability presented to Andersen by HIH was consistent with HIH's primary objective for the acquisition of FAI, as stated in the Part A statement455 , including the personal lines and distribution platform and the expected synergies to be derived from combining the two businesses. Had the budgeted profits been significantly lower so that they would not, or would barely, cover the future amortisation charge, or if a loss had been budgeted, then Andersen would have been required to consider recoverability and budgeted future profits in much greater detail. As it was, the budgets supported the commercial purpose of the acquisition and consequently no issue as to recoverability arose for Andersen.

• In respect of the 1999 audit, Andersen had no reason for any concern as to the accuracy, reasonableness or feasibility of the budgets used. On Couttas's evidence456 there would have been no reason for Andersen to query the fact that they were used. In those circumstances, it would not be expected, nor would it

be reasonably required in terms of AUS 208, that there would be extensive documentation of that issue. That being the case, there would not be expected to be documentation in the audit papers relating to overhead costs or reinsurance and other savings. Andersen submitted that, with respect to reinsurance and other savings, there was documentation from the company that established the veracity of these figures . 457

• Andersen's failure to document a particular issue cannot be a sound basis for making an adverse finding as to a failure to properly exercise a professional judgment, where the evidence shows that the resolution of the issue in question does not lead to any inference that its accounting treatment was ultimately

ihappropriate.

I do not think Andersen' s submissions properly reflect Couttas's evidence, which was that if Andersen was satisfied about the reasonableness and feasibility of the budgeted figures, there was no reason to query the fact that those figures were used. 458

Andersen further submitted that:

• No audit procedures were required for Andersen to establish that overhead costs were allowed for in the 2000 budgeted core earnings and AUS 208 did not require that Andersen document this fact as a matter that was either material to the audit or necessary to aid the understanding of a reader of the audit work . papers.

134 Th e audit f unction

• It was neither necessary, nor reasonable for Andersen to conduct, and AUS 208 did not require that Andersen document, audit procedures with respect to the veracity of the amount attributed to reinsurance and other savings for the group.

In its response to the issues paper, Andersen also contended that all costs, losses and overheads were brought to account before deriving future profitability.459

Counsel assisting submitted460, and I agree, that Andersen was required to approach HIH's assessment of the recoverability of goodwill arising from the acquisition of F AI with a heightened degree of professional scepticism in view of the following factors 46 1:

• There had been a significant deterioration in the value of the net assets of the FAI group in the six months between the last audited accounts of FAI (as at 30 June 1998) and the date of acquisition (1 January 1999). Much of this deterioration was as a result of trading losses and increased claims liabilities of the F AI group.

• There was practically no due diligence undertaken by HIH in respect of the FAI group prior to HIH's acquisition ofFAl.

In this light, it was critical that a rigorous assessment of the budgeted earnings attributable to the F AI businesses be undertaken. In the circumstances, I find it extraordinary that no such assessment was undertaken by Andersen. The fact that FAI's budgeted earnings exceeded the future amortisation charge is ofno relevance unless the reliability of the budgeted earnings was established. Any budget necessarily involves a degree of assumption, speculation and uncertainty. These factors should not have deterred Andersen from the rigorous assessment required.

I have considered the documentation said by Andersen to establish the veracity of the amount of budgeted profit before tax attributable to 'reinsurance and other savings of the group' (being $40 million of $59.2 inillion).462 That documentation was raised in Andersen's submissions and was not considered by Couttas . I note that the documentation included a spreadsheet summary which provided a total of $40.046 million under the heading 'key cost savings' in respect of the year ending 30 June 2000. 463 In my opinion, the savings summarised on the spreadsheet should have been the subject of the same rigorous assessment that was required in respect of the budgeted earnings attributable to the F AI businesses. There is no evidence that Andersen conducted such an assessment.

With respect to the other FAI businesses the earnings ofwhich were not included in the justification of the recoverability of the goodwill on acquisition of F AI, the 'F AI goodwill carrying value' paper stated:

FAI's other lines of business included similar lines of commercial insurance already underwritten by HIH. These lines of business have no real strategic value to HIH other than the F AI acquisition eliminated a competitor from the market. These lines of business are being absorbed into HIH ' s existing divisions where an extensive review was conducted and a cull of unwanted business made to bring this business to a minimum

The failure ofHJH Insurance 135

break even posttJOn. A similar plan is being executed for the overseas operations that are being integrated into existing HIH operations where possible, or assessed for closure where this is not possible. For the purposes of assessing goodwill carrying value no strategic value is attached to these operations. 464

Couttas expressed the opinion that it would not have been appropriate to base the assessment of the recoverable amount of the goodwill on acquisition ofF AI on the budgeted results of only certain lines of business unless a decision had been made to withdraw from all other lines of business and appropriate provision had been made for all losses associated with such withdrawal.465 Absorbing those lines of business into other parts of the group did not, in his opinion, constitute withdrawal from those lines of business. 466

In this respect, Andersen submitted:

• The justification for considering the budgeted results of selected lines of business when assessing the carrying value of goodwill was that the selected businesses were those that HIH considered to be the prize assets of F AI, those that it intended to continue to operate under the F AI brand and those which had driven the acquisition itself. Those businesses included the F AI personal lines business which, as well as being profitable in its own right, provided HIH with a vastly improved distribution network which was considered to be superior to any other insurer in Australia at that time. 467 As it was, the expected synergistic

benefits and the budgeted future profits from those businesses clearly supported the goodwill amount. Unless it was thought that the remaining businesses would have a negative impact on this assessment, the question whether there was a formal withdrawal or an absorption or integration was irrelevant to the goodwill ISSUe.

• Couttas's opm10n did not take account of how the integration was effected. What HIH did was to integrate some F AI lines with the equivalent divisions in the HIH group, with the books of the F AI lines managed by the HIH divisions. This meant that any new underwriting decisions would be made by HIH staff. The renewal decisions would be made using the HIH underwriting guidelines and would result in business that F AI had conducted that was outside of those guidelines not being renewed. The effective result was that the profitable business would be taken forward, while the unprofitable business would be managed in run-off. These were matters that were well known and fully understood by the audit team; there was in fact never any issue as to whether or not F AI had withdrawn from those lines of business.

• With this explanation in mind, Couttas's assertion that absorption in those terms did not constitute withdrawal from those lines is not relevant. The absorption meant that these other lines of business were (reasonably) not expected to have a negative impact on the goodwill assessment. Put simply, all that happened is · that HIH took over management of the run-off part of those lines of the F AI business and took over the renewal of the profitable lines of those

136 Th e audit JUn ction

businesses. This course of action was entirely appropriate and commercially sensible where there was no strategic value in retaining the F AI brand for the relevant classes of business and where some of those classes of business were, or had the capacity under HIH management to be, profitable.

I do not accept these arguments. In my view, having regard to the fact that no critical assessment was made by Andersen of the budgeted earnings of the selected F AI businesses, Andersen did not obtain sufficient appropriate audit evidence with respect to the carrying value of goodwill arising in respect of the acquisition of FAI as at 30 June 1999 as required by AUS 502 .

The 2000 audit

Adjustments made in determining net assets ofF AI at acquisition AASB 1013 , clause 7.1 stated the following:

Subsequent Identification of Assets and Liabilities

Where it becomes known, subsequent to acquisition, that assets or liabilities existed at the date of acquisition but were not recognised, an adjustment must be made in respect of those assets and liabilities and, where relevant, in respect of the amount of goodwill or discount on acquisition. A similar adjustment must also be made where assets and

liabilities which were unidentifiable at acquisition subsequently become identifiable.

A substantial proportion of the increase in the carrying value of goodwill at cost between 30 June 1999 and 30 June 2000 was attributable to what Andersen described as 'additional pre-acquisition claims deterioration that had been identified as a result of management or actuarial reviews'. Andersen concluded that this accounting treatment was in accordance with clause 7.1 and further stated that given the large parts of F AI' s business that went into run-off shortly after acquisition by HIH, the identification of deterioration as having been 'pre-acquisition' was often relatively simple. 468

Andersen's position with respect to this item was that469 once it is established that the liabilities existed, but were not recognised or capable of identification at the date of acquisition and that the goodwill balance was considered to be recoverable then the additional excess of cost over the cost of acquisition represented by these additional liabilities was required to be accounted for as goodwill.

Couttas gave evidence470 that once assets and liabilities have been measured at their fair values at the date of acquisition, any subsequent re-assessment of the fair values should not be adjusted against goodwill or discount on acquisition but instead should be recognised immediately in the profit and loss statement. Had Couttas's

interpretation of clause 7 .I been followed , the 'additional pre-acquisition claims deterioration that had been identified as a result of management or actuarial reviews' would have been expensed in the profit and loss statement for the year ending 30 June 2000 rather than being recognised as an increment in goodwill.

The failure ofHJH Insurance 137

Couttas's opinion gains apparent support from the use of 'recognised' in clause 7.1 in its defined sense of reported on or incorporated in amounts reported on in the financial statements. An unidentified claims liability is still reported on in th e financial statements as part of the provision fo r claims liabilities even if that provision is inadequate. Hence in the defined sense of the word it is recognised. 47 1

Couttas conceded472 that other accountants, in circumstances where it is absolutely clear that the re-assessment of the fair value of assets and liabilities acquired related to pre-acquisition events, have applied an alternative interpretation. This alternative interpretation was that adopted by Andersen and HIH in respect of the year ending 30 June 2000 and Couttas conceded that the alternative interpretation was a tenable view held by people with experience whose opinions he respected.473

The differing interpretations outlined above as to clause 7.1 of AASB 1013 had a significant impact upon the reported results of the HIH consolidated entity for the year ending 30 June 2000. Had Couttas' s interpretation been applied, substantial losses would have been reported. The present uncertainty and apparent inconsistency surrounding the application of clause 7.1 of AASB 1013 is unsatisfactory.

Assessment of the carrying value of goodwill as at 30 June 2000 With respect to the assessment of the carrying value of goodwill attributable to the acquisition ofF AI as at 30 June 2000, Andersen stated in its response to the issues paper that the assessment of recoverability was undertaken in two parts474 :

• First, $321 million of the balance was supported by the sale proceeds resulting from the Allianz transaction.

• Second, the residual balance of $95 million was considered to be recoverable based on the budgeted future profits of the remaining F AI businesses as set out in the paper provided by Fodera. 475 That the residual balance was reasonable, as well as recoverable, was further supported in that document by the demonstration that a business valuation, based on an appropriate industry earnings multiple, produced a value in excess of the goodwill balance.

Critical to Andersen's assessment that $321 million of the balance of goodwill attributable to the F AI acquisition was supported by the sale proceeds resulting from the Allianz transaction was that the value of the business implied by the Allianz transaction was $400 million. 476

The manner in which Andersen arrived at this conclusion was explained in Andersen's response to the issues paper477 , being that the consideration for the sale was $200 million for 49 per cent and what remained was worth at least a similar amount so the value of the business realised was assessed at $400 million.478

138 Th e auditfonction

Andersen submitted:

• The essential features of the Allianz transaction (as it was executed on 13 September 2000) were known. Those features were the payment of $200 million, up front, in order to compensate HIH for the additional value of the business that it was to contribute to the joint-venture, and that the 49 per cent stake which would remain with HIH was subject to a guaranteed sale at a value of not less than $125 million and a potential sale at a value of up to $500 million. The net excess of premium contributed by HIH was $600 million. HIH's share of the joint venture was 49 per cent on a total premium base of $1.4 billion.

• Those facts clearly supported the figure of $200 million which was the value that HIH had ascribed to its investment in the joint venture and which was presented to the audit committee by Fodera through the draft pro forma accounts. 479 The analysis was clear and simple and for those reasons it was neither necessary nor appropriate to document it. This is ·particularly so in circumstances where HIH represented to the audit committee and to Andersen that it was expecting a formal valuation from Deutsche Bank that would confirm this figure.

• Although the basis of the justification of value was simple, it was not inappropriate. The simplicity of the method of valuation ensured its reliability, which was the only thing that was relevant to the audit for the year ending 30 June 2000. The purpose of the exercise was not to enable an accurate value to be included in the accounts to represent the investment in the joint-venture, because the investment itself was not going to be accounted for as at 30 June 2000. The primary purpose of the justification of value was to support the carrying value of goodwill, principally that ofF AI, as at 30 June 2000. That purpose did not require an accurate valuation down to the last dollar and cent, but it did require that a value in an amount of at least $400 million be reasonably justifiable. The method adopted by Andersen provided that evidence. Buttle confirmed in his oral evidence that he saw the total value of the joint venture as 'at least' $400 million.480

Couttas expressed the opinion that it was incorrect to state that the consideration for the sale was $200 million and that accordingly the remaining 49 per cent interest held by HIH in the Allianz joint venture was worth a further $200 million for the following reasons48 1:

• Pursuant to the Allianz transaction, HIH divested its entire interest in a significant portion of its business in return for $200 million in cash, 49 per cent interest in the joint venture and rights under the option agreement.

• The $200 million in cash received from Allianz would in large part have been to compensate HIH for the fact that it contributed significantly more business to the joint venture than was contributed by Allianz.

The failure ofHIH Insurance 139

• As at 16 October 2000 it was known that the minimum value attributable to HIH' s 49 per cent interest in the Allianz joint venture was $125 million, being the value at which HIH could put its interest to Allianz pursuant to the option agreement.

• Andersen had not seen any evidence to substantiate the assertion that the value of the Allianz transaction was $400 million.

Andersen submitted that Couttas had no expertise as a valuer, as he conceded in cross-examination. As an expert auditor, Couttas gave evidence as to what would constitute sufficient appropriate audit evidence with respect to the carrying value of balance sheet items. His evidence has been considered in that light and goes no further.

Counsel assisting submitted that Andersen did not obtain sufficient appropriate audit evidence as to the value of the Allianz transaction as required by AUS 502. Andersen submitted that sufficient appropriate audit evidence was obtained. Andersen provided its view as to the value of the Allianz transaction in the context of its assessment of the carrying value of goodwill. This view is based upon a simple premise, yet it does not take into account the full circumstances of the transaction. In the absence of any further expert evidence as to what a reasonable view would have been as to the value of the Allianz transaction, I do not propose to make any findings in this respect.

Carrying value of remaining goodwill Andersen's assessment of the carrying value of the goodwill attributable to the acquisition of F AI remaining after taking into account the Allianz transaction as at 30 June 2000 (the residual goodwill) comprised a review of the paper entitled

'Goodwill FAI post joint venture' 482 prepared by HIH management.

This document was provided to Andersen on 16 October 2000, the date of its audit report in respect of the HIH 2000 financial report. 483 In its response to the issues paper, Andersen contended that discussions had been ongoing with HIH management, in particular Fodera, since early September 2000 and, by at least

12 September 2000, they had formed a preliminary conclusion that the book value of the residual goodwill was recoverable. 484

The 'Goodwill FAI post joint venture' paper485 relied in part on budgeted earnings for the businesses considered.

A document was retained in the work papers maintained in respect of the 2000 audit entitled 'Presentation Andersen October 2000' .486 Andersen stated in its response to the issues paper that this presentation was created by HIH and given by Fodera to Buttle, Pye and Fanning at a meeting held on or about 5 October 2000. The meeting was held to discuss Andersen's concerns, raised at the audit committee meeting on

12 September 2000, as to the reliability of the divisional budgeting process and as to whether the budgets previously presented for 2001 were achievable. 487

140 The audit function

Andersen submitted that a memorandum to the files from Pye entitled 'HIH review of 2001 budget' 48 8 discussed the presentation made by Fodera of 5 October 2000.489 The text of the memorandum is set out in the going concern section below.

With respect to the presentation made by Fodera on or about 5 October 2000 Andersen stated in its response to the issues paper that it regarded the forecasts made by Fodera as evidence that significant improvements in profitability were still achievable, though subject to some uncertainty. 490

Andersen submitted that the reliability of the Fodera presentation was critically assessed in the memorandum to the files from Pye entitled 'HIH- review of 2001 budget'. 49 1

Couttas gave evidence that the memorandum was essentially a commentary on a presentation that had been prepared by HIH for the ratings agency Standard & Poor's and there was no indication in the memorandum as to what procedures, if

any, were undertaken by Andersen to 492 :

• corroborate the prospective financial information that was embodied m the presentation document

• assess the reliability of the system used to generate the prospective information or the assumptions underlying the prospective information

• obtain support for the significant underlying assumptions.

In answer, Andersen submitted that this was an absurd criticism in circumstances where the presentation itself was specifically requested as corroboration for the original budget information and where Andersen had specifically requested that it be prepared by Fodera, the chief financial officer.

I do not accept that submission. Since the original budgeting information was found to be unsatisfactory, the Fodera presentation required separate consideration and corroboration.

Andersen further submitted that:

• Andersen's analysis of the Fodera presentation was also undertaken in the context of Andersen's considerable knowledge of the performance of the various HIH underwriting divisions, as a result of which Andersen, in particular Pye, was aware of:

the historical performance and profitability of the underwriting divisions

their historical performance against divisional budgets and consequently any inadequacies in divisional budgeting

factors impacting on the historical and likely fu ture performance and profitability of the underwriting divisions

and consequently Pye was able to assess criticaliy the Fodera presentation.

Th e failure of HIH Insurance 141

• Andersen's detailed knowledge of the various underwriting divisions was gained as a result of the considerable substantive audit work performed in respect of each of the underwriting divisions. In particular, Andersen completed a Business Performance Review (BPR) in respect of each underwriting di vision which relevantly involved:

a detailed review by audit personnel of the various HIH divisions' underwriting results for the audit year, including comparison of actual results to both budget or forecast figures and prior year results

discussion with relevant HIH management of trends and variances from budget or forecast and prior year results and other relevant matters including, for example, whether the division was currently, or was proposed to be, in run-off

identification of any matters warranting further audit work as a consequence of the first two steps

documentation of the outcome of the above. 493

• As a result of the BPR process, Andersen had a detailed knowledge of the past and likely future performance of the various underwriting divisions.

Notwithstanding Andersen's submissions, documents created by Andersen at or about the time of completion of the 2000 audit raised concerns as to HIH's ability to achieve income and cash flow forecasts and limitations of the budgetary process. These included:

• A SMART report dated 24 October 2000 (eight days after the signing of the audit report in respect of the HIH 2000 accounts), which assessed HIH's ability to achieve income and cash flow forecasts as 'very poor'. 494 This assessment had been downgraded from 'poor' m the SMART report dated

29 August 2000.495

• A management letter prepared by Andersen after completion of the 30 June 2000 audit, bearing what appears to be a printing date of

29 August 2001, which contained the following comments in relation to the budgeting process of HIH:

Each year of the past 6 years HIH has missed its budgeted result by a significant margin and has had to rely on major reinsurance and other transactions to recover the position. This approach in [sic] not sustainable and some fundamental reforms are required to address the limitations of the current budgeting process. 496

• A memorandum entitled 'HIH going concern memoranda' prepared by Pye in April 2001, which stated:

142 Th e auditfonction

Business Plans

A detailed business plan by class of business and geographical segment was prepared by management for the banks (document attached).

The document outlines where management believes the various profit improvements are likely to be, which key markets are expected to harden, etc.

The key message for the presentation is that significant reserve strengthening has been done plus significant work to improve premium rates, etc to improve underlying performance.

However, our final conclusion was that the forecasts would be difficult to achieve given HIH's historical performance and weaknesses in the budgeting process documented in our management letter.

Hence, our primary reliance for going concern purposes was the Allianz deal delivery $400m of tangible assets and APRA's approval of the LOC's for the Australian insurers. 7

As to the analysis set out in the 'Goodwill F AI post joint venture; paper498 above:

• With respect to the workers compensation division:

The earnings figure of $15.5 million used in the residual goodwill justification corresponded to the actual core earnings of the workers compensation division for the year ending 30 June 2000, whereas the budgeted core earnings figure for that division for the year ending

30 June 2001 was $10.5 million. 499

Fodera gave evidence that the budget for the year ending 30 June 2001 underestimated the non-risk bonuses500 and the portfolio was subsequently sold for $130 million. 501

A schedule of consolidated core earnings indicated that F AI made a negative contribution of $4.5 million to the overall core earnings of workers compensation of $15.5 million for the year ending 30 June 2000. 502 Fodera said that the amount attributable to F AI in the schedule related to the run-off for that portfolio. From 1 July 1999 the book had been renewed through HIH and HIH C&G. 503

Fodera said that it was impossible to identify F AI' s contributions to core earnings and that his estimate of 50 per cent was from the knowledge obtained from the merger in 1999. 504

• With respect to the New Zealand division:

Earnings figures for the business in New Zealand were not kept separately for FAI and HIH.505

Fodera said that the estimate of 20 per cent attributable to FAI business was based upon the premium acquired from F AI that was now being

The failure ofHIH Insurance 143

underwritten totally by HIH C&G staff on the same basis that the book with HIH C&G had been underwritten. 506

• With respect to the professional indemnity division:

Fodera said that all corporate business of F AI was put in run-off and th e renewal book was put into HIH C&G. 507

The earnings figure used in the residual goodwill justification corresponded to the budgeted core earnings figure for the division for the year ending 30 June 2001. The actual core earnings figure for the year ending 30 June 2000 was $0.7 million.508

• With respect to the property division, the earnings figure of $7.8 million used in the residual goodwill justification corresponded to the actual core earnings figure for the property division for the year ending 30 June 2000, whereas the budgeted core earnings figure for that division for the year ending 30 June 200 1 was $5.4 million.509

• As to why he used actual earnings in some cases and budgeted earnings in others in the goodwill justification, Fodera stated that he was trying to come up with a core earnings figure that was sustainable for those books of business and he looked at each book of business. He used his knowledge of those books to determine what he felt was a sustainable profit figure going forward. 5 10

• Fodera denied that he had worked backwards to provide justification for the carrying value of the residual goodwi11. 511

• The F AI businesses not sold to Allianz contributed core earnings losses of approximately $22 million in the year ending 30 June 2000. 512 If the businesses which contributed to that loss were in run-off and their liabilities had been sufficiently provided for, that fact would not preclude the recognition of goodwill in respect of the remaining businesses. However, that was not the case; HIH had not withdrawn from those lines of business.

• Further, it was not possible to measure the contributions of former

F AI businesses to the continuing businesses as a result of their absorption into HIH.

It was noted above that Andersen held and expressed the view that HIH's budgets were systematically unreliable and did not provide adequate support for the goodwill booked. The problem was compounded in the calculations in support of the carrying value of the remaining goodwill because the calculations adopted either budgeted contributions to core earnings, or prior period contributions to core earnings, depending upon which was the higher.

The inadequacy of the HIH budgeting process and goodwill calculations were immediately demonstrated by the results of the next six months. The financial report for the six months to 31 December 2000 showed that F AI contributed a loss of

144 Th e auditfimction

$83 .1 million to a core earnings loss of $108.4 million, against a budgeted core earnings profit of $36.6 million. 513

With respect to the matters raised above as to the analysis set out in the ' Goodwill FAI post joint venture' paper5 14 , Andersen submitted:

• Fodera denied that he worked backwards to come up with his justification.515 Even if this denial is not accepted, it does not follow that the process was incorrect. What was required was not a valuation of goodwill, but a justification of the carrying value of goodwill. Fodera was only required to justify goodwill

in an amount of around $100 million and that is what he did. The starting point for that justification would obviously be the goodwill figure that was to be justified.

• The way the justification was presented5 16 was to identify the figure for the carrying value that required support and then to identify what earnings multiple would be necessary to apply to the budgeted future profits to demonstrate that the carrying value was supported. If the elements of that process- the budgeted future profits and the multiples- were reasonable, then QED. The lowest multiple that demonstrated that result was a multiple of seven, which was considered by Andersen to be a fairly conservative multiple by industry standards. The assessment that Andersen undertook was of the reasonableness of the multiple, rather than an assessment of the reasonableness of the budgets (that had already been the subject of considerable concern, discussion with management and assessment with respect to other matters, including going concern). As it was, the multiple of seven indicated that budgeted profits were far in excess of the amount needed to support the required amortisation charge. 517

• In those circumstances, the specific matters noted with respect to the analysis were minor and had no material bearing on the reasonableness of the conclusion reached by Andersen or the basis for that conclusion. On this basis, Andersen did not respond to them.

Andersen submitted that the evidence showed that there was considerable documentation available, including the documentation from the BPRs, the position paper provided by Fodera51 8 and the detailed forecasts in the Fodera presentation that were provided to and were assessed by Andersen519, which amounted to

sufficient appropriate audit evidence for Andersen to conclude upon the carrying value of the remaining businesses.

In my opinion, the inconsistencies, anomalies and difficulties with respect to the analysis set out in the 'Goodwill FAI post joint venture' paper520 described earlier required that each of the components making up the basis of earnings for the remaining F AI businesses was rigorously assessed to ensure that the approach taken was reasonable. I do not consider the matters raised as minor. This, coupled with the concerns with respect to HIH' s ability to achieve income and cash flow forecasts and limitations of the budgetary process, leads to the conclusion that Andersen did

Th e f ailure of HIH Insurance 145

not obtain sufficient appropriate audit evidence as to the carrying value of the residual goodwill as required by AUS 502.

In Chapter 20 I find that no goodwill should have been recognised from the F AI acquisition in excess of the amount of $321 million which was accepted by the auditors having regard to the Allianz joint-venture. It follows that the amount of goodwill recognised at 30 June 2000 from the F AI acquisition was overstated by $84 million and that profit was also overstated by that amount.

Carrying value of US goodwill The journal entry by which goodwill attributable to the US operations was written off was posted as at 31 December 2000. 521 On its face, this contradicts the memorandum to the files prepared by Pye 522 which suggested that the write-off was effected as at 30 June 2000.

Andersen submitted that because there was an increase in the amount of goodwill attributable to the acquisition of F AI in the same amount as the write-off that was necessary in relation to the goodwill attributable to the US operations, the balance of goodwill in the 2000 financial report was not materially misstated in consequence of the relevant journal entry not being posted until 31 December 2000.

Andersen submitted that there was no concern (or reasonable basis for concern) that the goodwill balance for F AI could not carry this additional charge. I refer to my findings above about Andersen's audit work with respect to the carrying value of residual goodwill.

It remains that there is no evidence to establish how it came to be that the fair value of the net assets of F AI at acquisition was considered to decline by an amount exactly equivalent to the goodwill attributable to the US operations. Andersen submitted that there was no doubt that 'there were fair value adjustments that could be included to effect [the additional charge to goodwill equivalent to the amount of the US goodwill]'. I could not find sufficient evidentiary support for this proposition.

In any event, in my view, only the goodwill which could be recovered through the Allianz joint venture ($321 million) should have been recognised.

It follows that the amount of the goodwill attributable to the US operations ($23.9 million) ought to have been written off. There was no basis for increasing goodwill attributable to the acquisition of F AI by this amount. Consequently, operating profit (before and after income tax) for the year ending 30 June 2000 was overstated by this amount and was therefore materially misstated. 523

146 The auditfonction

21.5.8 Going concern assessment

AASB 1001 'Accounting policies' contained the following requirements:

• When preparing a financial report, an assessment must be made of the entity's ability to continue as a going concern. 524

• A financial report must to be prepared on a going concern basis unless It IS intended either to liquidate the entity or to otherwise wind up its operations, or there is no realistic alternative but to do so, and in such a case, the financial report is to be prepared on a liquidation basis. 525

• In assessing whether the going 'concern basis is appropriate, it is necessary to consider all available information for the foreseeable future, which is at least, but not limited to, twelve months from the reporting date. 526

• Where the financial report is prepared on a going concern basis, but material uncertainties exist in relation to events or conditions that cast doubt upon the entity's ability to continue as a going concern, those uncertainties must be disclosed in the summary of accounting policies. 527

The 30 June 1999 and 30 June 2000 financial reports were prepared on a going concern basis. There was no disclosure of uncertainty as to going concern in the summaries of accounting policies in those financial reports.

Australian auditing standard AUS 708 'Going concern' provided:

• An entity is a going concern where it is expected to be able to pay its debts as and when they fall due and to continue in operation without any intention or necessity to liquidate or otherwise wind up operations. 528

• The relevant period going forward is 12 months from the date of the auditor's current report. 529

• The auditor should obtain sufficient audit evidence that it is appropriate, based on all reasonably foreseeable circumstances facing the entity, for management to prepare financial statements on a going concern basis. 530

• The auditor should specifically assess the risk of going concern problems as part of the audit planning process.53 1 Where, as a result of the initial risk assessment, the auditor considers it highly improbable that the going concern basis should be questioned, it is not necessary to design additional procedures specifically to test for the existence of going concern problems. 532

• When a question arises regarding the appropriateness of the going concern assumption, the auditor should gather sufficient appropriate audit evidence to attempt to resolve that question. 533

• When going concern problems have been identified, they are to be considered in light of any mitigating factors that may exist. 53 4

Th e failure ofHIH Insurance 147

• The auditor has a responsibility to determine if preparing the financial statements of the entity on a going concern basis is appropriate, significantly uncertain535 or inappropriate. The characterisation determines the auditor's reporting requirements. 536

• When consideration of mitigating factors has had a significant effect upon the auditor in forming the opinion that the going concern basis is appropriate, the auditor should specifically consider the adequacy of the disclosure in the financial report of matters such as the principal conditions which initially caused the auditor to question the going concern basis and management' s plans and other mitigating factors. If the disclosures considered necessary by the auditor are not made, the auditor should express a qualified opinion.537

No reference to issues affecting the going concern basis was made in Andersen ' s audit reports in respect of the 30 June 1999 and 30 June 2000 financial reports.

The 1999 audit

Andersen' s AOP manual provided that various procedures should be carried out in respect of assessing the going concern assumption as part of an audit engagement, including the documentation of the assessment of the going concern basis in a 'Going concern practice aid' (practice aid).

In a practice aid dated 16 September 1999, Andersen identified risk indicators which existed that indicated there was a risk that the going concern assumption may have been questionable. 538 Andersen noted that there were conditions which might mitigate these identified risks (to be described in a memorandum) and concluded that there was no substantial doubt about the appropriateness of the going concern assumption. 539

A memorandum to the files was prepared by van de Walle also dated 16 September 1999 which considered these risk indicators and stated:

148

The Going Concern Practice Aid indicates that a few risks indicating the going concern assumption may be questionable.

Risk Indicators and Mitigating Factors

Point b. Adverse Financial Trends

Over the past few years there have been recurring underwriting losses, which have been increasing each year. The profit/loss trends are as follows :

U/w Investment Core

Year loss revenue earnings

Dec 1995 (7.4) 61.4 51.2

Dec 1996 (18.1) 96.1 75.0

Dec 1997 (33.8) 114.4 80 .1

Dec 1998 (73.4) 126.5 56.4

June 1999 (18 months) (173.7) 229.0 58 .5

Th e audit function

For the 18 months to 30 June 1999 the split of the underwriting loss between the HIH and the FAI business is $209M loss and $35M profit respectively. Underwriting losses are covered by investment earnings, in order to produce a net insurance profit for the year. The core earnings result for the 6 months to June 1999, however was only $2M.

In addition, there has been negative cash flows from operations of $341M for the 18 month period. Cash flows for the 12 months to December 1998 was an outflow of $49M, thus the major portion of the negative cash flows was incurred in the final 6 months. Cash flow trends are as follow s:

Operating Total

Year , cash flow cash flow

Dec 1995 153.1 (31.7)

Dec 1996 128.3 201.4

Dec 1997 166.8 (94.5)

Dec 1998 (48.6) 78 .0

Jun 1999 (18 months) (341.4) 447.6

F AI Operating cash flows for the 12 months to June 1998 and June 1997 were positive.

Mitigating factors and Management plans

Despite continuing underwriting losses and negative operating cash flows, HIH have produced a total insurance profit for the 18 month period. The purchase ofFAl at December 1998 has been a major impact on the results for the period. Much of the deterioration in F AI was considered pre­ acquisition and posted through Goodwill. Now that management have had time to consider the stance of F AI, they can consider strategies for the coming year, in order to improve results.

Point f Internal Difficulties

Since the purchase of F AI, there have been a large number of key personnel from within FA! departing the organisation. Many of the F AI personnel did not choose to join the HIH organisation, other personnel did move over to HIH, but within the last 6 months nearly all key personnel have departed or are planning to depart. Key personnel leaving the organisation include the Financial Controller, the entire research division, and many personnel from within the underwriting divional [sic] areas and Financial services division.

The failure ofHIH Insurance 149

150

Mitigating factors and Management plans

Within HIH over the past few years there have been a number of new appointments to previously poor performing divisions. The senior personnel within the organisation have the desired industry skills and generally many years experience within the HIH organisation. Management are currently in the process of reviewing all job descriptions within the organisation to ensure there are no overlaps and that all key tasks are appropriately assigned to experienced personnel.

Point i. Aggressive Accounting

The group is under significant earnings pressure to meet the expectations of market analysts. Deteriorating operating performances also have an impact on the pressures to improve performance through other means . Accounting policies in most areas are generally regarded as aggressive, and given the number of judgmental areas in an insurance company the scope for adjustment is significant.

Historically at HIH there have been discrepancies between management, actuary and AA claims reserves estimates, particularly for the longer tail classes of business. There is also potential for these estimates to change from year to year as more information becomes available. HIH also have large valuations of goodwill, which have been increasing over the past few years, following the various purchases of controlled entities. In summary the goodwill trends are as follows:

Goodwill after

Year Goodwill at cost amortisation

December 1996 48.8 29.5

December 1997 67 .2 42 .1

December 1998 70 .0

June 1999 392.1 346.5

Mitigating factors and Management Plans

Reserving has become more in line with the actuary, following discussions to ensure the actuary and HIH are using the same assumptions in their modelling. In addition the reserving estimates were closer to the AA likely estimates in the current year than prior year, indicating an improvement in general reserve estimation across the HIH group.

The Goodwill relating to the FAiacquisition was $275M (consideration of $300M less NT A of $25M). This is to be amortised over 20 years. Asset writedowns in relation to F AI have generated goodwill, but were considered necessary and appropriate so as not to adversely impact the future results of the insurance activities of the Group.

Overall Assessment

The risk of continuing adverse results has been mitigated through substantial reinsurance programs which have reduced retention levels going forward.

Th e auditfimction

Based on our consideration of the identified indicators in the aggregate and given the mitigating factors and management plans documented above there is no substantial doubt about the appropriateness of the going­ concern assumption as at 30 June 1999. 540

Counsel assisting submitted that Andersen did not obtain sufficient appropriate audit evidence to resolve concerns regarding the appropriateness of the going concern basis underlying the preparation of the 1999 financial report, as required by AUS

708. That submission finds support in the evidence of Couttas. 541

Andersen submitted that the identification of the risk indicators did not, individually or collectively, raise or constitute a going concern problem. Andersen submitted that, after a consideration of the risk indicators, there was insufficient evidence to raise any concern that Andersen was required to resolve.

However, AUS 708 stated that, in order to conclude that it was unnecessary to design specific additional audit procedures, it must have been 'highly improbable' that the going concern basis should be questioned. 542 That this was the case is not readily apparent from van de Walle's memorandum, which raised serious matters with respect to HIH group cash flow and underlying profitability.

Further, AUS 708 provided that identified going concern problems were to be considered in the light of any mitigating factors, particularly management plans. 543 The van de Walle memorandum explicitly considered 'mitigating factors and management plans' , suggesting that there was in fact a question arising regarding the appropriateness of the going concern assumption which required sufficient appropriate audit evidence for its resolution.

AUS 708 also required a specific assessment of the risk of going concern problems as a part of the audit planning process. 544 This requirement appears not to have been complied with by Andersen, who submitted that the documentation referred to above was completed at or about the date of the audit report, being

9 September 1999. 545

The 2000 audit Background From at least early September 2000, the appropriateness of the going concern assumption in the preparation of the 2000 financial report was an audit issue. 546

In a practice aid prepared by Pye and signed by him in October 2000, Andersen identified conditions which indicated a risk that the going concern assumption may have been questionable. Those conditions were adverse financial trends and ratios, liquidity problems, internal difficulties, external difficulties, management deficiencies, investor reactions and aggressive accounting. 547

Th e failure of HIH Insurance 151

The practice aid548 :

• recorded a typewritten comment that:

The results of the group have been significantly below expectations, there are significant intangible assets in the balance sheet dependent upon future profitability and there are concerns as to whether the group can meet local solvency requirements under the Insurance Act. Cash flow are sign ificantly negative. Proposed changes to solvency will make it more difficult for HIH to maintain solvency.

• indicated that there were conditions to mitigate the identified risks and recorded a typewritten comment that:

Management is negotiating the sale of a significant portion of the business that may provide sufficient additional capital to maintain remaining operations [ie the Allianzjoint-venture transaction]

• recorded a typewritten comment that there was still substantial doubt about the appropriateness of the going concern assumption as:

the potential sale has not yet been confirmed and significant concerns exist over solvency and the realisable value of major assets.

Part III of the practice aid concerned management's plans and stated that it was to be used where there existed substantial doubt about the appropriateness of the going concern assumption. By way of handwritten annotation549 :

• It was indicated that management plans to overcome the going concern Issue included the liquidation of assets.

• In answer to the question posed on the form 'Does the prospective information indicate that the management's plans will enable the entity to continue as a going concern?', the answer was 'yes'.

• The overall conclusion was that the gomg concern question had been satisfactorily resolved.

Andersen submitted that550 :

• The typewritten parts of the practice aid were prepared on 6 September 2000 after a number of internal discussions relevant to the wider going concern issue had taken place within Andersen up to that date. These discussions concerned various issues which were relevant to going concern, were to be discussed at a meeting to be held between Andersen personnel and Williams, Fodera and Cassidy on 7 September 2000 and were to be discussed with the audit committee on 12 September 2000.

• The handwritten comments were completed in October 2000 after further consideration of management's plans and execution of the Allianz agreement.

152 The audit fonction

There were three principal areas which gave rise to the substantial doubt recorded in the practice aid 55 1:

• the net tangible asset position of the HIH group and absence of prudential margms

• the treatment of assets provided as security for letters of credit in the context of statutory solvency calculations

• whether there was a breach of any of the debt covenants of any of the HIH group's borrowing facilities.

The second and third items are considered elsewhere in this report.

It is clear that the primary reason that Andersen considered that the substantial doubt as to going concern, created by the deteriorating net tangible asset position of the HIH group and absence of prudential margins, had been resolved was the entry by HIH into the Allianz joint venture on 13 September 2000. 55 2 Andersen stated in

its response to the issues paper that a further basis by which this issue was resolved was a presentation made by Fodera on or about 5 October 2000. 553 A memorandum entitled 'HIH going concern memoranda' prepared by Pye in April2001 suggested that limited reliance was placed upon this presentation. 554

A memorandum to the files from Smith dated 5 October 2000 entitled ' Contract review' documented an overview of the provisions of the Allianz joint-venture agreement. 555

A memorandum to the files from Smith dated 5 October 2000 entitled 'Impact of contract' stated as follows 556:

Purpose

To document the issues arising for HIH in relation to the sale of certain business lines to the N during the year. The purpose of our analysis is to ensure that the remaining operations are viable.

Results

1. Uncertainty associated with the contract

2. Whether contract provides support for the intangible balance

The contract specifies that AIL will pay $200m (the fixed amount) up front to HIH.

(AA analysis required)

3. Impact on future operations

AA obtained a budget for 2000- 2001 from HIH that has been prepared on the basis of theN going ahead. (attached)

Th e failure of H!H Insurance 153

Core underwriting loss Operating profit after tax

30/06/01 Budget

89m 57m

30/06/00 Actual

102m 18m

The abnormal items that tum the underwriting loss round to a profit are the same as for the current year actuals with the exception of a caption ' income on $200m from Allianz at 6.8'. This implies that HIH will invest the full balance of the Allianz cash receipt.

In addition, the consolidated results include a receipt from the Allianz business (that HIH are predicting will result in a small loss). The N should be equity accounted for rather than consolidated in HIH's books.

The budget appears over-optimistic. (AA to assess validity) [Refer work performed on going concern AP section/57

A document was retained in the work papers maintained in respect of the 2000 audit entitled 'Presentation: Arthur Andersen, October 2000'. 558

Andersen contended in its response to the going concern issues paper that this presentation was created by HIH and given by Fodera to Buttle, Pye and Fanning at a meeting held on or about 5 October 2000. Andersen stated that the meeting was held to discuss Andersen's concerns, raised at the audit committee meeting on

12 September 2000, as to the reliability of the divisional budgeting process and as to whether the budgets previously presented for 2001 were achievable. 559

Andersen stated in its response to the issues paper that a memorandum to the files from Pye entitled 'HIH- review of 2001 budget' 560 discussed the presentation made by Fodera on 5 October 2000. 561 The memorandum stated:

154

Attached is a presentation made to Standard and Poors for their assessment of HIH's credit rating. Dominic ran me through the presentation to assist us in understanding the Group post the Allianz deal. This document will also assist in us in concluding on the carrying value of deferred assets (ie. goodwill and tax losses).

Allianz Venture

Section one covers the detail of the Allianz deal. The impact on the balance sheet is to increase the NT A of the Group from <$0.40 to in excess of $1. Deutsche Bank is preparing a valuation that will formally value theN as at 1 January 2001 , expected to be around $400m. Hence, HIH will book an investment of $200m (ie. 49% of $400m) in addition to

the cash received from Allianz. Of this $400m, $330m will be used to reduce goodwill, $1Om for realisation of tax losses, $1Om for transaction costs and redundancies, $25m for a possible premium shortfall on Swiss Re ($200mx3x5%) and $25m for IT. TheN is to take Gen+ for at least 2 years. At that time the system will be worth a net $48m. If the N scraps the system HIH will have a $48m write-off to book, if it remains in use then there is a zero impact. HIH has taken the mid-point and is confident

The auditfonction

that it would take Allianz many years to develop a new system given the complexity of the process.

Refer Allianz contract and analysis for a more detailed assessment of the terms of the deal.

Profit & Loss Analysis

Overall there is expected to be little impact on the 2001 year given HIH has only given up $300m of premium and the N will not commence until 1 January 2001. Naturally premium growth should hold premium levels steady in the first year. The only major impact will be th e reduction in the goodwill amortisation charge and no extra ordinary items are expected.

Householders--expected to turn in a similar performance to last year, although no catastrophes expected such as Sydney hailstorms.

Private Motor- similar to above with no real changes expected.

Commercial-Expected to break even as premiums harden. However, business will remain marginal.

Business Packages- Steadily improving as rates strengthen. Will again be a marginal result.

CTP NSW- Strong profits again. Forecasts are conservative as under estimated premium rate on renewal and assumes government changes will reduce profits. However, evidence to date suggest loss ratios are too conservative and prior year loss ratios will be achieved.

CTP Queensland-This year the market has been opened to new players and HIH budgeted lower premiums and higher marketing costs as new players bought market share with low premiums. However, premiums have remained above budgeted levels and hence HIH is expecting margins

in line with prior year.

The above divisions will be controlled by Allianz from 1 January 2001. The following divisions will remain in the HIH group.

Professional Indemnity-The 2000 result reflects stronger provisioning made for the Law Society (including some ' catch up'). 2001 result reflects a 10% premium increase which is reflected in a 10% fall in the combined ratio. Key assumption is that there is no further deterioration in the prior years and that the Law Society 'catch up ' was sufficient.

Property-Premium expected to be in line with prior years. However, unusually low loss ratios last year so expecting more normal claims ratios. Note the 1999 results were badly affected by the Sydney hailstorms and the Victorian gas crisis.

Workers Compensation (Risk)- Expected to remain profitable given the steady improvements in W A following changes to cap claims. The 1999 includes additional reserving for F AI claims.

Worker Compensation (Non-risk)- Continued to streamline the operations. Assumes a base level of performance bonuses will be achieved to ensure high returns. However, no super performance bonuses budgeted as they are harder to achieve and hence only booked when confirmed.

Th e failure ofHIH Insuran ce 155

156

Public Liability- Rates slowly improving and non-performance risks continue to be weeded out. However, in acknowledgment of the actuaries concerns a further $30m of deterioration in prior year losses has been allowed for. There is heavy internal actuarial involvement in premium setting to ensure the most recent years will generate suitable returns. To date the latter years are performing as hoped and budgeted for.

Travel-Continues to generate reasonable returns. Some major claims last year affecting results. Have increased premiums in some of the higher risk categories (US travel and seniors) to compensate for the higher claims these areas generate.

Marine- Business now just reflects Australia, international Marine has been split amongst the relevant regional operations. No major claims last year and expecting steady results next year.

Disability and Other- income from IRS and Premium Funding have been reclassified to this section hence the jump in profits from 'Other'. Disability itself remains breakeven.

Head Office-Australia-Net expense recoveries down once personal lines moved to N. Investment income is allocated to the divisions based on a set return of 6% . Any returns above 6% are retained in head office. For 2001 investment revenue is expected to be less than the prior year.

Cotesworth-Significant turnaround expected because of significant drop in reported incidents for the 9 months to 30 September as compared to the prior year with the European storms in December 1999 and the hurricanes in the US. This impacted both the Marine and Non-marine syndicates. One marine syndicate has been closed and the marine business in 1688 has also ceased. Hence, HIH budgeting for a positive trend in 2001 based upon the performance of the 2000 year to date. However, it is acknowledged that the result is heavily dependent upon their being no increase in the frequency major disasters for the remainder of the year for this result to be achieved. HIH's results appear in line with current market expectations for Llyods [sic] but it is acknowledged that the results are vulnerable if a series of major disasters hit.

Americas-Results remain poor primarily because of the Californian operations. Claims inflation remains very high with little sign of slowing. Although premiums are being pushed up it does not appear to be fast enough. US management budgeted a breakeven position, however, head office has cut that by $30m on the assumption that claims continue to deteriorate. The American operations are for sale, however, the market discounts to NT A are very high. Management believes all American operations can be sold at book or above with the exception of the Californian operations that may be put into run-off if market discount on sale is too high .

New Zealand- Decline in premium reflects the loss of workers compensation business as it was re-nationalised. A quota share treaty has lapsed and hence exchange commission income is missing pushing up costs. Has purchased a share in a 3rd party claims handling business that is pushing up other income.

Th e audit function

Asia-Premium base is continuing to grow but the business remains marginal. However, need JV partner to make fully utilise the infrastructure in place. Partners are currently being sought.

Balance Sheet

Based upon the structuring of the transaction receipts there will be no change in the net assets of HIH, however, NT A will treble. Goodwill remaining will consist of $75m for FAI (NZ and Workers) and the remaining international operations to total $145m, down from $475m. Other exposures as discussed in the attached are believed to be fully reserved and no further problems have been allowed for.

Business Strategy

Confirms a basic 'steady as she goes' approach designed to consolidate in key markets and ensure profit targets remain achievable. Trend analysis suggest key markets trending in the right direction. Management appear to be committed to closing divisions where profitable underwriting does not appear possible. As noted above biggest risk lie in the US , UK and public

liability areas.

Financial Outlook

Summarises the financial position of the group in 2006 once the JV interest is sold to Allianz. with only 2 key changes in assumptions, US operations gone and public liability is breakeven. As the analysis suggests, the HIH result remains stable over that time.

Conclusions

Based on the attached analysis the significant improvements in profitability are achievable provided the insurance cycle remains in an upward swing (ie. improving premium rates and a fewer catastrophic events than in recent years as HIH do not have prudential margins to absorb this). Strong commitment is also needed by management to

restructure unprofitable operations and reduce costs as the group shrinks in size.

The results may also be affected by adverse developments in some of open exposures as has occurred this year (eg. in many of the FAI areas currently in run-off). Refer to a separate memo on our conclusions on the exposures.

However, based upon the attached it is considered that HIH will make sufficient returns in key jurisdictions to support the carrying value of goodwill and tax losses with one exception, goodwill on the Californian operations. A separate analysis will be performed on this. A separate paper will also deal with the technical aspects of the recoverability of the tax

losses (ie whether they are groupable against future profits, etc.).

It should also be noted that the profit assumptions are on the basis that the Group maintains a sufficient S&P rating to continue to write corporate business. If S&P drop HIH's credit rating 2 or more notches then the Allianz deal can be cancelled and forecast premiums in key business lines are unlikely to be achieved. 562

The failure ofHIH In surance 157

The purpose of a memorandum entitled 'HIH going concern memoranda' prepared by Pye in April2001 was described as being to summarise conclusions on the going concern questionnaire, presumably the practice aid document. The memorandum stated that a file note was prepared in respect of this matter in October 2000 (at the time of signing off on the audit report), but Andersen had not located this document. The memorandum stated:

158

There were 3 principal areas where going concern was considered. A comparison of the HIH Group's NT A of $148m to the net written premiums of $2.4b prima facie indicated that HIH was well below the ' rule of thumb' of 20% of premiums/capital ratio (ie. the APRA solvency rule). Such a thin NTA position and no prudential margins meant HIH would be unlikely to survive any further deterioration in reserves. Secondly, HIH had secured letters of credit over the assets of the Australian insurance companies to underwrite the Lloyds operations. We required assurance that the letters of credit would not need to be deducted from net assets in the solvency calculations, making 2 of the 3 Australian licensed entities insolvent under the Insurance Act. The final point was whether the Group remained with the debt covenants of its various

borrowing facilities.

Liquidation of Assets

HIH agreed to sell its Australian personal lines business into a JOint venture with Allianz. The effect of the deal was HIH retained 49% of the combined entity and received $200m for its greater contribution of business to theN. A put/call arrangement existed over the remaining 49% at a floor price of $125m. However, Deutsche Bank provided a valuation to support management' s view that the long-term value of the asset was $400m and hence HIH's 49% share was worth $200m.

The effect of this transaction was to recover $325m in goodwill and other soft assets of $75m (FITB, deferred software development costs, etc.). Hence increasing NTA backing up to $550m and achieving the rule of thumb benchmark of 20% of premiums underwritten. Therefore, by

1 January (the effective date of the Allianz deal, the NT A would be restored to a satisfactory level).

However, the Allianz deal did not address the immediate problem of the letters of credit as at 30 June 2000 for the solvency of the individual insurers (ie. the insurance companies had to be solvent at year end). The Insurance Act is silent on contingent liabilities and hence there were no definitive guidelines on how to treat the LOCs for solvency. We required assurance that APRA would not view the LOCs and related secured assets as capital allocated to the UK and couldn 't be used for Australian solvency.

Dominic Fodera (CFO) consulted an industry expert from KPMG. At our insistence, the CFO and KPMG met with APRA on several occasions to discuss the treatment of the LOC ' s for solvency. APRA concurred with management's view that as the LOC's are contingent to liabilities and the UK reserves are fully reserved, then LOC did not need to be deducted from solvency. KPMG provided a letter summarising the meeting outcomes. Consequently, we were able to conclude the licensed Australian

Th e auditfonction

companies were solvent. (Note: APRA returns included a note explaining the LOC's and the conclusion reached.)

The final issue related to compliance with debt covenants. A thorough review of the debt covenants was performed and HIH was found to be in compliance with all of them. The asset sales further improved the margin of compliance. Just prior to signing the audit report S&P downgraded HIH's credit rating to BBB+. However, this did not trigger any defaults with either the debt covenants or the Allianz transaction.

Business Plans

A detailed business plan by class of business and geographical segment was prepared by management for the banks (document attached).

The document outlines where management believes the various profit improvements are likely to be, which key markets are expected to harden, etc.

The key message for the presentation is that significant reserve strengthening has been done plus significant work to improve premium rates, etc to improve underlying performance.

However, our final conclusion was that the forecasts would be difficult to achieve given HIH's historical performance and weaknesses in the budgeting process documented in our management letter.

Hence, our primary reliance for going concern purposes was the Allianz deal delivery $400m of tangible assets and APRA's approval of the LOC' s for the Australian insurers.

Report Modification

Based on the above, it was concluded it was appropriate for the financial statements to be prepared on a going concern basis. However, our report was modified with an emphasis of matter paragraph on Swiss Re contract. Although the accounting treatment was satisfactorily resolved following consultation with Swiss Re and a letter of advice from KPMG (and APRA's approval of the contract), a concern remained over HIH's ability to recover the benefits. Given the current changes to HIH' s business (and any future changes), it may be difficult for HIH to ensure continuity of the contract (refer to audit report for details of qualification). Hence, our audit report was modified. Whilst not a going concern qualification, it did highlight the changes to HIH that may result in changes in the value of this asset and consequently net tangible assets'. 563

Andersen stated in its response to the issues paper564 that the missing memorandum referred to in this document was the memorandum to the files from Pye entitled 'HIH- review of2001 budget' 565 set out above.

Analysis of cash .flow Both the memorandum to the files from Pye dated 4 April 2001 566 and the memorandum to the files from Pye entitled 'HIH- review of 2001 budget' 567 specifically referred to the impact of the Allianz transaction upon the balance sheet

of the HIH consolidated entity in considering the appropriateness of the adoption of

Th e failure ofHJH Insurance 159

the going concern assumption. There was no documented analysis of the impact of the Allianz transaction upon the cash flows of the HIH group.

An analysis of the cash flow statement indicated a worsening in the cash outflow from operating activities from negative $341.4 million in 1999 to negative $678.3 million in 2000 and an overall decline in cash from a $447.6 million inflow in 1999 to a $185.3 million outflow in 2000. Prior to entry into the Allianz transaction, Andersen highlighted negative cash flows on the practice aid as an issue.

568 Andersen stated in its response to the issues paper that the negative cash flow issue was raised at the audit committee meeting on 12 September 2000.569 Andersen stated that it understood that the causes of the cash outflows were the Hannover premium ($200 million), the Swiss Re premium ($1 00 million) and the various HIH and F AI portfolios that were in run-off. 570

Andersen submitted that, with respect to the Allianz transaction:

• Andersen believed that the cash flow impact would be neutral, if not positive. Andersen believf)d that the assets to be transferred to the trust would have a similar duration to the liabilities (for example, some long-term investments to match the long-tail CTP liabilities). 57 1

• Andersen' s consideration of the effect on cash flow was critically influenced by its understanding572 that the $200 million in cash paid by Allianz was to be available to meet claims liabilities.

• Andersen believed that the $200 million cash would relieve HIH of the burden of having to fund $200 million of its current claims liabilities from its own resources. 573

• On the basis that the $200 million was to be available, it would have insulated HIH from any cash flow issues that would have arisen by reason of the different periods that the Allianz contract stipulated with regard to the cycle of contributions to, and distributions from, the trust.

• Andersen also understood that the trust would receive its share of premiums less agreed deductions monthly and would distribute surplus cash quarterly. 574

• In these circumstances, it was reasonable for Andersen to believe, as it did, that the absence of cash flow would not have a material impact on its

assessment of the effect of the Allianz transaction in the context of going concern.

• This was reinforced by Andersen's understanding of the effects of the transaction in many other areas (particularly the support that they provided for the goodwill balance) which were significantly and overwhelmingly positive to the going concern assessment.

Andersen further submitted that there were no cash flow forecasts in existence (or made available to Andersen) at the time of the audit. Andersen submitted that it

160 The audit f unction

would not have been possible, or reasonable, for Andersen to have produced its own forecasts without significant assistance from HIH management because of the large number of assumptions that Andersen would have had to make with regard to the co nduct of the ongoing business. 575

The Allianz transaction represented a fundamental change to the manner in which HIH would derive its cash flows.

Following the Allianz transaction, instead of receiving $1 billion per annum of premium income, directly, HIH would be entitled to 49 per cent of premium income estimated to be $1.4 billion (approximately $700 million per annum) and a payment of $2 00 million. However, rather than receiving the premium income as it came in, the joint-venture agreement provided for the receipt of premiums by the manager, who was to account to the parties in their respective proportions for all premiums received after setting aside, amongst other things, reserves to be established to meet claims on business written from 1 January 2001 (including incurred but not reported claims), as well as commissions, settlement costs and operating expenses. The difference was not to be paid to HIH but to the trustee of the trust. 576 The trust was to be established in respect of, among other things, any policy liability arranged by the manager, and also in respect of 'in force policies' as at 1 January 2001. 577 HIH was required to transfer to the trustee assets with a market value of not less than the reserves required to satisfy liabilities under those policies. Clause 13 .1 0 of the joint­ venture agreement provided for the trustee to release money to HIH following the end of the months of December, March, June and September annually, if there was sufficient money, after the manager had determined and notified the reserve amount for that month. 578 The reserve amount for the months of March and September was to be determined within sixty days of the end of those months, after an actuarial valuation. 579

In my opinion, the adverse effects of these features of the Allianz transaction upon cash flow should have been appreciated by Andersen. They included not only the requirement to set aside assets and incoming premiums and to meet policy liabilities under both new and existing policies, but also delay in remitting any credit balance of new premiums until after actuarial valuations conducted in respect of the March and September periods were completed.

By reason of Andersen' s existing concern as to negative cash flow and the fundamental changes to HIH's operating cash flows brought about by the Allianz transaction, it was imperative that there be a thorough analysis of forecast cash flow taking into account the Allianz transaction in any assessment of the appropriateness

of the going concern assumption. 580 The fact that forecast cash flows were not available, as submitted by Andersen, ought to have been a matter of deep concern to it. Andersen should have insisted that such forecast cash flow information be prepared and properly analysed.

Th e failure of HIH Insurance 161

Analysis of forecast profit and loss With respect to the presentation made by Fodera on or about 5 October 2000 Andersen stated in its response to the issues paper that58 1:

• It regarded the forecasts made by Fodera as evidence that significant improvements in profitability were still achievable, although subject to some uncertainty.

• It was not necessary, for this purpose, that the forecasts be met in full. Fodera's forecasts were based, amongst other things, on the Allianz transaction. They formed part of the entirety of the information gathered during the audit process upon which Andersen relied in forming the going concern conclusion.

Andersen submitted that the reliability of the Fodera presentation was critically assessed in the memorandum to the files from Pye entitled 'HIH- review of 2001 budget' . 582

Couttas gave evidence about that memorandum. 583 Of particular note was his evidence that:

• The memorandum was essentially a commentary on the content of the presentation that had been prepared by HIH for the ratings agency Standard & Poor' s. There was no indication in the memorandum as to what procedures, if any, were undertaken by Andersen to:

corroborate the prospective financial information that was embodied in the presentation document

assess the reliability of the system used to generate the prospective information or the assumptions underlying the prospective information

obtain support for the significant underlying assumptions.

• The memorandum was subject to a number of caveats which served only to reinforce the significant uncertainties identified by Andersen regarding the HIH group's ability to continue as a going concern.

In this respect, Andersen submitted:

• The uncertainties identified by Pye in this memorandum were directly linked to risk indicators identified in the going concern practice aid. They did not reinforce any uncertainties, but were simply a restatement of the risk indicators by reference to the specific instances of uncertainty that were perceived to lead to risk. Specifically, 'insurance cycle remains in an upward swing' in the memorandum was linked to 'adverse financial trends' in the practice aid, 'strong commitment by management' was linked to 'management deficiencies' and maintenance of a 'sufficient S&P rating' was linked to 'investor relations'. These were not additional uncertainties, but were the matters that gave rise to the instances of uncertainties. The conclusion in the memorandum was clearly reached after careful consideration of them.

162 Th e audit jUnction

• Andersen's analysis of the Fodera presentation was also undertaken in the context of Andersen's considerable knowledge of the performance of the various HIH underwriting divisions, as a result of which Andersen, in particular Pye, was aware of:

the historical performance and profitability of the underwriting divisions

their historical performance against divisional budgets and consequently any inadequacies in divisional budgeting

factors impacting on the historical and likely future performance and profitability of the underwriting divisions

and consequently Pye was able to assess critically the Fodera presentation.

• Andersen' s detailed knowledge of the various underwriting divisions was gained as a result of the considerable substantive audit work performed in respect of each of the underwriting divisions. In particular, Andersen completed a BPR in respect of each underwriting division which relevantly involved:

a detailed review by audit personnel of the various HIH divisions' underwriting results for the audit year, including comparison of actual results to both budget or forecast figures and prior year results

discussion with relevant HIH management of trends and variances from budget or forecast and prior year results and other relevant matters including, for example, whether the division was currently, or was proposed to be, in run-off

identification of any matters warranting further audit work as a consequence the first two steps

documentation of the outcome of the above. 584

• As a result of the BPR process, Andersen had a detailed knowledge of the past performance, and likely future performance, of the various underwriting divisions.

Notwithstanding Andersen's submissions, documents created by Andersen at or about the time of completion of the 2000 audit raised concerns as to HIH's ability to achieve income and cash flow forecasts and limitations of the budgetary process. These included:

• A SMART report dated 24 October 2000 (eight days after the signing of the audit report in respect of the HIH 2000 accounts), which assessed HIH's ability to achieve income and cash flow forecasts as 'very poor'. 585 This assessment had been downgraded from 'poor' m the SMART report dated

29 August 2000. 586

The failure ofHJH Insurance 163

• A management letter prepared by Andersen after completion of the 2000 audit, bearing what appears to be a printing date of 29 August 2001, which contained the following comments in relation to the budgeting process of HIH:

Each year of the past 6 years HIH has missed its budgeted result by a significant margin and has had to rely on major reinsurance and other transactions to recover the position. This approach is not sustainable and some fundamental reforms are required to address the limitations of the current budgeting process. 587

Significant uncertainty In light of the above and having particular regard to the lack of analysis of forecast cash flow , Andersen did not obtain sufficient appropriate audit evidence to resolve the substantial doubt and significant uncertainty that existed as to the appropriateness of the going concern assumption.

Given this, it is noteworthy that in the 2000 financial report there was no disclosure as to:

• any significant uncertainty regarding the ability of the consolidated entity to continue as a going concern

• the principal conditions that raised doubt about the ability of the consolidated entity to continue as a going concern

• the extent to which the financial report included appropriate adjustments, if any, relating to the recoverability and classification of recorded asset amounts or to the amounts and classification of liabilities that might be necessary should the entity not continue as a going concern.

Andersen concluded that it was appropriate to adopt the going concern assumption in the preparation of the 2000 financial report.

When consideration of mitigating factors, in particular management's plans, had a significant effect upon the auditor in forming the opinion that the going concern basis is appropriate, AUS 708 required that the auditor should specifically consider the adequacy of the disclosure in the financial report of matters such as:

• the principal conditions which initially caused the auditor to question the going concern basis, including as appropriate, management's evaluation of their significance and possible effects

• management's plans and other mitigating factors , including relevant prospective financial information as appropriate. 588

Management's plans and mitigating factors were identified in the memorandum to the files ofPye dated 4 April2001 as:

164

... our primary reliance for going concern purposes was the Allianz deal delivery $400m of tangible assets and APRA ' s approval of the LOC's for the Australian insurers. 589

Th e auditfimction

At note 45 'Subsequent events' to the 2000 financial report, the following was disclosed with respect to the Allianz transaction:

On 13 September 2000 a joint-venture agreement was signed between certain controlled entities and Allianz Australia Insurance Limited (a wholly-owned subsidiary of Allianz AG). The joint-venture business will comprise Allianz and those controlled entity's private motor; householders; CTP (New South Wales and Queensland); and rural and commercial business sourced through all distribution channels with the exception of international brokers.

The terms of the joint-venture provide Allianz with 51% equity and the consolidated entity with 49%, effectively reducing the consolidated entity's retail annual premium by around $300 million to $700 million. Under the agreement, Allianz will pay the consolidated entity $200 million

upfront and have a call option to acquire the consolidated entity's joint­ venture interest at fair market value after 5 years (up to a maximum of $500 million with a minimum of $125 million). The consolidated entity has a put option, exercisable at the minimum valuation at any time.

The joint-venture is due to commence on 1 January 2001, subject to certain conditions precedent, including approvals and the

maintenance of an appropriate claims paying rating. 90

Andersen submitted that:

• The conditions which initially caused Andersen to consider the going concern basis included the thin net tangible asset base, large amounts of intangibles (each of which was disclosed in and easily discernible from the balance sheet) and long-term reinsurance arrangements (as disclosed by an emphasis of matter paragraph).

• Management's plans and mitigating factors included the Allianz transaction, in relation to which HIH's intentions were adequately disclosed in the financial statements.

Andersen submitted that the adequacy of the disclosure was confirmed by the substantial volume of media and analyst scrutiny and comment that followed publication ofthe financial statements.

However, the disclosure with respect to the Allianz transaction referred to above provided disclosure of only the basic features of the transaction. The manner in which the Allianz transaction was considered to deal with the issues raised as to the appropriateness of the going concern basis (that is, the thin net tangible asset base and large amount of intangibles) was not disclosed. 591

In Chapter 20 I have found that if appropriate adjustments had been made to the financial statements in 1999 and 2000, there would have been at least a serious doubt as to whether the group accounts could properly have been prepared on a going concern basis. If that were the case further write-downs may have been necessary. In reaching those conclusions I have had regard to a range of matters not all of which were or should have been known to Andersen. I do not, by reason of

Th e failure ofHJH Insurance 165

those findings, express any adverse opinion in respect of Andersen 's audit work on the going concern assumption additional to those expressed in this chapter.

21.6 Final comments

21.6.1 Independence

Actual independence was defined in the relevant auditing standard, AUP 32, as ' the achievement of actual freedom from bias, personal interest, prior commitment to an interest, or susceptibility to undue influence or pressure'. 592

It is rare that there will be definitive evidence that an auditor acted in a particular manner because he or she lacked independence. Unless the auditor has deliberately sought to compromise his or her independence, the auditor is unlikely to identifY or acknowledge that an adjustment to attitude or behaviour was made by reason of a lack of independence. There is no suggestion, nor could there be, that any member of the Andersen audit team deliberately or consciously acted in a manner that compromised their independence. That is not to say that I agree with individual decisions they took during the course of the respective audits, but at a general level the evidence did not lead me to conclude they were actually swayed.

Nonetheless, a subjective assessment can not provide a complete answer in a situation where a person can unknowingly be compromised. I must also analyse Andersen's behaviour to determine objectively whether there are any matters demonstrating, or from which the inference may be drawn, that Andersen was not independent of HIH.

Both the auditor and the audit firm must be, and be seen to be, independent. When considering perception it is easy to look both at the firm and the individual. It is not quite so easy when the focus of attention shifts to actuality rather than perception. In some circumstances general policies may be promulgated, or the conduct of individuals may be adopted in such a way that the firm itself is compromised. But audit work is done by individuals and audit decisions are taken by individuals. Generally speaking, it is necessary to look at the conduct of individuals to see if the firm is actually compromised.

As I have already said, I have no doubt that the circumstances were sufficient to raise a perception of lack of independence. The factors leading to that conclusion include that three members of the HIH board were former partners of Andersen; the reactions of HIH management and then Andersen itself to the meeting between Davies, Gooley, Head and Gardener in March 1999, including Davies' replacement as audit engagement partner; and the pressure upon Andersen partners to procure additional fees from non-audit work by maintaining their relationship with audit clients.

166 The auditfonclion

One of the matters from which the inference that Andersen lacked independence may be drawn is that following the meeting between Davies, Gooley, Head and Gardener in March 1999 and Davies' subsequent replacement as audit engagement partner, no further meetings were held between Andersen and non-executive

directors of HIH in the absence of HIH management. 593

I have a strong view that meetings between the auditors and the non-executive directors would have been appropriate. The circumstances surrounding the events of 1999 may well have sent a message to at least some members of the Andersen audit team that meeting non-executive directors of HIH in the absence of HIH management could result in their removal fro m the audit team. Pye gave evidence on at least three separate occasions of his understanding that HIH management tended to 'shoot the messenger' if it did not like the message. 594

In particular, the following circumstances heightened the need for Andersen to meet the non-executive directors independently of HIH management:

• Pye' s evidence that he was uncomfortable with the practice of non-executive members of the audit committee meeting HIH management prior to audit committee meetings and in the absence of Andersen, because he felt that the non-executive directors were coming into audit committee meetings with pre­ conceived views595

• Andersen's comments in SMART reports that it was not always certain that non-executive members of the audit committee fully understood the significant adjustments to operating results596

• the failure of HIH management to report to the audit committee Slee's consistent warning of the need for HIH to maintain a solvency margin597

• the evidence of Davies and Pye that they could not recall any occasion upon which the audit committee accepted and adopted Andersen' s view in preference to management's opposing view. 598

But do these matters signal an actual lack of independence? In this respect, I note that there is little, if any, evidence that it was part of the audit practice or protocol for meetings of that nature to occur before March 1999. I note also Buttle's evidence that he did not consider such meetings to be necessary. The fact that I regard the attitude as wrong does not mean that the reason advanced by Buttle is spurious and reflects adversely on independence.

I note also that Davies 'upset' the management of HIH so much so that Fodera attended on Knoblanche to seek his removal from the audit. Without detracting from what I have said about the 'message ' Knoblanche might have delivered to HIH and to Andersen by acceding to the request (if that is a fair way to describe it), the catalyst for Fodera's approach is hardly consistent with labelling Davies as compliant. Nor does Buttle' s conduct in late 2000 in taking decisive action concerning the Pacific Eagle Equities matter and by insisting on an emphasis of matter note sit comfortably with characterising him as lacking in independence.

The f ailure of HIH insurance 167

Of the main players, that leaves Pye. It also leaves what I might describe as the catalogue of individual matters that I have found to be less than satisfactory in the conduct of the audit and which are mentioned in this and other chapters.

Pye' s concern about a tendency for HIH to 'shoot the messenger' needs to be considered carefully. It is difficult to conclude otherwise than that it did cause Pye to modify his conduct in some respects. But does that necessarily signal an actual lack of independence? It is important not to use hindsight (and particularly where the circumstances are as spectacular as they are here) to second guess what motivated a person at a time in the past. In establishing and fostering a practitioner and client relationship, a whole range of considerations come into play. Behaviour and methodology may be changed for a variety of reasons, both personal and professional, and which may essentially be matters of judgment.

I have found that the audit process miscarried in various ways and in varying degrees. In support of the submission that Andersen's independence was actually compromised, counsel assisting placed emphasis on the accumulation of these instances and, in patticular, on the work done and conclusion reached on the going concern assumption. This is clearly a matter of substance. But it must be remembered that, while Pye was intimately involved in the 2000 audit and in the work concerning the going concern assumption, it was Buttle who made the decision on the assumption. I have found that there should have been at least a serious doubt whether the group accounts could properly have been prepared on a going concern basis. That does not mean it demonstrates a lack of independence by Buttle and, unless his will was overborne by Pye (as to which there is no evidence), it says little about Pye's independence.

One matter that caused me ·particular concern was the preference share issue discussed in Section [23.9]. Buttle was the architect of a scheme designed to resolve a problem that had arisen during the preparation of the accounts to 30 June 2000. The scheme was fundamentally flawed but it found its way into the accounts of two of the subsidiaries. Pye signed the audit opinion for the subsidiaries. Buttle should not have proposed the scheme. Pye should not have signed an audit opinion that was wrong. I gave serious consideration to the question of whether their conduct reflected an actual lack of independence. But Buttle took the 'decisive action' that I have mentioned in an earlier paragraph after the preference share was conceived. I have found that Pye simply overlooked an important matter. In those circumstances, and after serious deliberation, I have concluded that the share . issue does not reflect an actual lack of independence.

Despite all of the negatives I find, on balance, that the perception of lack of independence that I have found to exist did not translate to a reality that reflects a 'susceptibility to undue influence or pressure'. 599

168 The audit fonction

21.6.2 Approach to AASB 1002

Elsewhere in the report I have dealt with three transactions the accounting treatment of which raised questions under AASB 1002. That standard deals with events occurring after the reporting date. The three transactions to which I refer are:

• the Swiss Re reinsurance contract entered into in January 2000 and accounted for as at the 31 December 1999 balance date

• the Hannover Re reinsurance arrangement entered into on about 25 August 1999 and accounted for as at the 30 June 1999 balance date

• the issue of preference shares in F AI Insurances Ltd, an idea conceived and implemented in October 2000 and accounted for as at the 30 June 2000 balance date.

In each instance part (but certainly not all) of the problems identified in the inquiry was that the accounting treatment approved by the auditors proceeded on a basis that could not be sustained on the proper interpretation of AASB 1002. There is, of course, a danger in drawing broad inferences from a limited number of specific examples, but if this illustrates the general approach and attitude of Andersen to the construction and application of AASB I 002 it was flawed. There is nothing ambiguous or unclear about AASB 1002. But it is an important provision and one that is likely to arise for consideration on a regular basis. I do not make any finding against Andersen of systemic error arising from these examples. But if the approach to AASB I 002 has been carried forward to the successors in title to the Andersen business or indeed other sections of the accounting profession, the problem should be noted and addressed in, for example, continuing education programmes.

21.6.3 Conclusion

Andersen's audit work in relation to the 1999 and 2000 audits was characterised by a lack of sufficient audit evidence to support its conclusions. It is surprising that Andersen was so willing to accept positions put by HIH management without obtaining sufficient appropriate audit evidence in respect of those positions.600 In particular, Andersen exhibited a willingness to embrace the Allianz transaction as a panacea in respect of a number of critical and fundamental audit issues in the 2000 audit without obtaining sufficient analytical evidence about the transaction and its potential financial consequences.

Users of financial statements have varying expectations about the audit certificate. In my view Andersen's approach to the audit in 1999 and 2000 was insufficiently rigorous to engender confidence in users as to the reliability of HIH's financial statements. This detracted from the users' ability to properly appreciate HIH's true financial position.

The failure of HIH Insurance 169

4

10

I I

12

13

14

15

16

17

18

19

20

2 1

22

23

170

Canada (Atto rney General) v Canada (Commission of Inquiry on the Blood System) [1997] 3 SCR 440 at [62].

Research Manager - US & Global - December 1998, together with any updates made in the period to September 1999 will be referred to as the 1999 AOP manual. Research Manager - Australia - June 2000 will be referred to as the 2000 AOP manual. Andersen have confirmed that these are the applicable AOP manuals.

1999: 1.2, AOPR.0001.004; 2000: 1.2, AOPR.0008.002.

1999: 1.2, AOPR.OOO 1.004; 2000: 1.2, AOPR.0008.002.

Including broad statements derived from specific pronouncements of authoritative professional bodies and more detailed requirements adopted as matters of Andersen poli cy.

1999: 1.2.1, AOPR.OOOI.006; 2000: 1.2.1 , AOPR.0008 .003.

1999: 1.3 , AOPR.0001.008 at 008 ; 2000: 1.3, AOPR.0008.005 at 005 .

1999: 1.3, AOPR.0001.008 at 009 ; 2000: 1.3, AOPR.0008.005 .

Par. 5 of APS 1.1 'Conformity with Auditing Standards' and pars 7 and 8 of AUS I 02 'Foreword to Australian Auditing Standards and Guidance Statements'.

See also APS 4, APS 5 and AUP 32 .

AUS 206 par. 2.

AUS 206 par. 7. See also par. 21 of APS 4.

AUS 206 par. 8.

See also par.l4 of APS 4.

See also par. 13 of APS 4 and par. 51 of AUP 32.

See also par. 18 of APS 4. Paragraph 6 of AUS 206 further stated 'In making a decision to accept or retain a client, the audit firm's independence and ability to serve the client properly and the integrity of the client's management are to be considered'.

Referencing was the critical review of the auditors ' report issued by Andersen and the related financial statements by an experienced person who was usually a senior (although sometimes a semi-senior or manager). It 'serves as an additional check that the information in the report and the financial statements is supported by the working papers ': 1999: 9.2.2, AOPR.0005.199; 2000: 9.2.2, AOPR.OOJ1.090.

Advisory Partner: 'The role of the advisory partner is to provide additional client contact and to assist the engagement partner in rendering high-quality service to the client in all areas of the Firm's practice' (1999 : 2.1.1.3 , AOPR.0001.173; 2000: 2.1.1.3 , AOPR.0008.153).

1999:2. 1.1 , AOPR.OOOI.168 ; 2000: 2.1.1 , AOPR.0008.148.

1999: 2.1.1, AOPR.0001.168; 2000: 2.1.1 , AOPR.0008. 148.

1999: 1.7.3, AOPR.0001.044 at 044 ; 2000: 1.7 .3, AOPR.0008.034 at 034.

1999: 1.7.3, AOPR.0001.044 at 047 ; 1.7.4, AOPR.0001.049 at 049 to 050; 2000: 1.7.3 , AOPR.0008 .034; 1.7.4, AOPR.0008.039 at 039 to 040.

1999: 1.7.4, AOPR.0001.049 at 051 ; 2000: 1.7.4, AOPR.0008.039 at 041.

The audit function

24

1999: 1.7.3, AOPR.0001.044 at 047; 1.7.4, AOPR.0001.049 at 051; 2000: 1.7.3, AOPR.0008.034 at 037; 1.7.4, AOPR.0008.039 at 041. 25 1999: 1.7 .7, AOPR.0001.102 at 103; 2000: 1.7.7, AOPR.0008.089 at 090. 26

AND .1668.0007.0149at0149. 27 AND.1392.0008.0318 at 0336. 28

AARA.0346.0007 at 0025 . 29 1999: 2.6.1.2, AOPR.0001.243; 2.6.1.2.2, AOPR.0001.246; 2.6.1.2.3, AOPR.0001.248; 2000: 2.6.1.2, AOPR.0008.227; 2.6.1.2.2, AOPR.0008 .230; 2.6.1.2.3, AOPR.0008.232. 30

AND.6010.0211 at 0211 ; AND.l668.0007.0149 at 0149; AARA.0215.0180 at 0198; AND.1384.0001.0008 at 0023; AA.0006.0004.0052 at 0052. 31

32

System for managing acceptance and retention tool. 1999:3.1.6, AOPR.0002.023; 3.1.7, AOPR.0002.025 . 33 2000: 3.2.2, AOPR.0008.461. 34

Although not defined in the AOP manual, 'maximum*' appears to be the highest risk classification that could be assigned to an audit engagement under SMART. 35 HIH was assessed as a maximum risk client from 1998 to 2001 : AND.l392.0008.0342

at 0344; AND.l384.0001.0084 at 0087; AND.l678.0035.0084 at 0087; AARA.0570.004 at 008; AND.l917.0001.0001 at 0005 to 0006. 36 2000: 3.2.2, AOPR.0008.461. 37

1999: 3.1.5.1, AOPR.0002.020. 38 2000: 3.2.3, AOPR.0008.463. 39

40

1999: 3.1.5 .3, AOPR.0002.022; 2000: 3.2.1.3, AOPR.0008.452.

1999: 3.1.5 .3, AOPR.0002.022; 2000: 3.2.1.3, AOPR.0008.452. 41 AND.1392.0008.0342 at 0344; AND.l384.0001.0084 at 0087; AND.1678.0035.0084 at 0087; AARA.0570.004 at 008; AND.1917.0001.0001 at 0005 to 0006. 42

AND. 1392.0008.0342 at 0344; AND.1384.0001.0084 at 0087; AND.l678.0035.0084 at 0087; AARA.0570.004 at 008; AND.1917.0001.0001 at 0005 to 0006. 43 T17211116toT17213/2. 44

1999: 2.3.1, AOPR.OOOJ.207; 2000: 2.3.1, AOPR.0008.188. 45 1999: 2.3.1, AOPR.0001.207; 2000: 2.3.1, AOPR.0008.188. 46

1999: 2.3.1.1, AOPR.0001.208; 2000: 2.3.1.1, AOPR.0008.189. 47 1999: 2.3.1.2.2, AOPR.0001.212; 2000: 2.3 .1.2.2, AOPR.0008 .193 . 48

1999: 2.3.1.2.1, AOPR.0001.211 ; 2000: 2.3.1.2.1, AOPR.0008.192. 49 A P AJE is 'An entry that is proposed by the auditor to correct an error or misstatement, in an account balance, that has been detected by performing audit tests': 1999: 1.8.16,

AOPR.0001.146 at 147; 2000: 1.8.16, AOPR.0008.131 at 132. 50 AND.l384.0001.0084 at 0085; AARA.0215.0119 at 0120; AND.l678.0035.0084 at 0085; AARA.0570.004 at 005; AND.1917.0001.0001 at 0002 . 51

WITS.0222.001 at 003 par. 23. 52 WITS .0216.001 at 004 par. 8 (Knoblanche).

The failure of HIH insurance 171

53

WITS.0214.001 at 005 par. 15 (Gooley). 54 AND.6183.0004. 55

AND.6178.0020. 56 WITS .0266.001 at 005 to 006 par. 10. 57

WITS.0266.001 at 009 par. 15. 58 WITS.0266.001 at 009 to 010 par. 15 (Underwood). 59

AND.l392.0008.0342 at 0344; AND.l384.0001.0084 at 0087; AND.l678.0035 .0 084 at 0087; AARA.0570.004 at 008 ; AND.1917.0001 .0001 at 0005 to 0006. 60 AND.6136.0309 at 0310. 61

AND.6136.0309 at 0309. 62 WITS .0222.001 at 009 par. 59 (Jackson). 63

AND.6174.0033 at 0034; ANDR.001 7. 001 at 003 ; AND.6171.0073 at 0091 ; AND .6 175 .0038 at 0041; AND.6097.0124 at 0128; AND.l947.0005.0051. 64 AND.6183.0009; AND.6183 .0018; AND.6183.0021A; AND.6183.0022;

AND.6183 .0030; ANDR.0001.026; WITS.0266.001 at 010 to 011 pars 17 and 18 (Underwood). 65 AND.6183.0009. 66

AND.l392.0008.0342 at 0344; AND.l384.0001.0084 at 0087; AND.l678.0035 .0084 at 0087; AARA.0570.004 at 008; AND.l917.0001.0001 at 0005 to 0006. 67 1999: 3.1.5 .3, AOPR.0002.022; 2000: 3.2.1.3 , AOPR.0008.452. 68

AND.6136.0309 at 0309. 69 AND.6178.0020. 70

AND.6136.0309 at 0310. 71 1999: 3.1.5.3, AOPR.0002.022; 2000: 3.2.1.3, AOPR.0008.452. 72

WITS.0222.001 at 003 par. 23 (Jackson). 73 AND.6178.0020. 74

1999: 3.1.5.3 , AOPR.0002.022; 2000: 3.2.1.3, AOPR.0008.452. 75 AND.6178.0020. 76

WITS.0266.00 1 at 005 to 006 par. 10 77 WITS.0266.001 at 009 par. 15 (Underwood). 78

AND.6183 .0009; AND.6183.0018; AND.6183 .0021A; AND.6183 .0022; AND.6183.0030; ANDR.0001.026; WITS .0266.001 at 010 to 011 pars 17 and 18 (Underwood). 79

1999: 2.1.1.1, AOPR.0001.169; 2000: 2.1.1.1 , AOPR.0008.149; WITS.0214.001 at 002 par. 6(a) (Gooley). 80 Outlined in s. 2.1.1.1 of the AOP manual: 1999: 2.1. 1.1 , AOPR.OOO 1.169; 2000:

2.1.1.1, AOPR.0008 .149. 81 1999: 2.1.1.1, AOPR.0001.169 at 170; 2000: 2.1.1.1, AOPR.0008.149 at 150. 82

A PRJE is 'An entry proposed by the auditor to move an amount from one account/financial statement caption to another, to correct the presentation of accounts

172 The auditfonction

for financial reporting purposes': 1999: 1.8.16, AOPR.0001.146 at 147 ; 2000: 1.8.16, AOPR.0008.131 at 132. 83

84

For example, where the engagement partner was assigned for the first time to a particular client or industry: 1999: 2.8.5.1, AOPR.0001.397; 2000: 2.8.5.1 , AOPR.0008.378.

1999: 2.8.5.1, AOPR.0001.397; 2000: 2.8.5.1, AOPR.0008 .378. 85 Andersen submitted that the fact that this occurred in 1999 is consistent with Davies ' evidence at Tl7554/33 to Tl7554/43 ; WJTS .0046.001 at 001 to 003 pars 6 to 8 and 12. 86

87

88

89

90

91

92

93

94

95

96

97

98

99

Andersen submitted that the extent to which that occurred was not the subject of detailed or complete evidence.

Tl7554/33 to T1 7554/43 ; WITS.0046.001 at 001 to 002 pars 6 to 8. WITS.0046.001 at 003 par. 12.

The Arthur Andersen Audit.

With Pye as engagement manager: AARA.0568.052 at 053 .

Those items were listed in Part I of the 1999 questionnaire and Part II of the 2000 questionnaire.

AARA.0568.052 at 053 ; AND.1674.0001.0572 at 0575.

AARA.0568.052 at 052; AND.1674.0001.0572 at 0575 .

AARA.0568.052.

WITS.0046.001 at 002 par. 8.

1999: 2.1.1.1, AOPR.0001.169; 2000: 2.1.1.1 , AOPR.0008 .149 .

Suttle was approved as auditor ofHIH by APRA on 10 December 1999: AND.1365.0055.

Tl7066/41 to T17067 /15 Tl7073/47 to T17074/29. 100 Tl7069/57 to T17070/3; Tl7071 /51 to Tl7071154. Suttle's evidence was raised by

Andersen. 101 ANDR.0005.00 1A at 001A to 002A; ANDR.0002.100A at 106A and 115A; ANDR.0002.083A at 093A and 094A. 102

ANDR.0005.001A at 001A to 002A; ANDR.0002.100A at 106A and 115A; ANDR.0002.083A at 093A and 094A. 103 ANDR.0002.126 at 126. 104

Although one version of the questionnaire indicated that the representations contained within the questionnaire were signed by Pye (as engagement partner) and Fanning (as engagement manager) on 16 October 2000 (AND.1672.0005.0425 at 0427), another version of the questionnaire (which was also signed by Jackson as concurring partner)

indicated that the representations were signed by Suttle (as engagement partner) and Pye (as second engagement partner) on 16 October 2000 (AND.1674.0001.0572 at 0574). 105

AND.l674.0001.0572 at 0573 to 0574. 106 1999: 2.1.1.1, AOPR.0001.169; 2000: 2.1.1.1, AOPR.0008.149.

The failure of HIH Insurance 173

107

1999: 2.1.1.2, AOPR.0001.172; 2000: 2.1.1.2, AOPR.0008.152 see also WITS .0214.001 at 002 par. 6(b) (Gooley); WITS.0222.001 at 005 pars 37 to 38 (Jackson); WITS.0046.001 at 002 par. 9 (Davies); Tl7554/43 to Tl7554/46 (Davies). 108

1999: 2.4.1, AOPR.0001.216_001; 2000: 2.4.1, AOPR.0008 .201. 109 1999: 2.4.2, AOPR.OOOl.216_002 ; 2000:2.4.2, AOPR.0008.202; see also WITS.0222.001 at 005 par. 37 (Jackson). 110

1999:2.4.3, AOPR.OOOl.216_006; 2000: 2.4.3, AOPR.0008.206. 111 1999: 2.4.5.1, AOPR.OOOI.219; 2000: 2.4.5 .1, AOPR.0008.210. 112

1999: 2.4.5.2, AOPR.0001.221; 2000: 2.4.5.2, AOPR.0008.211. 11 3 1999: 2.4.5.3, AOPR.OOOI.223 ; 2000: 2.4.5 .3, AOPR.0008.212 . 114

1999 : 2.4.5 .3, AOPR.0001.223 . 115 2000: 2.4.5.3 , AOPR.0008.212. 11 6

1999: 2.4.5.1 , AOPR.0001.219; 2000: 2.4.5.1, AOPR.0008.210. 11 7 1999: 2.4.1, AOPR.OOOl.216_001; 2000: 2.4.1, AOPR.0008.201; 1999: 2.4.4, AOPR.0001 .216_009; 2000: 2.4.4, AOPR.0008 .2 08. 11 8

1999: 2.4.4, AOPR.OOO 1.216 _ 009; 2000: 2.4.4, AOPR.0008.208. 11 9 WITS.0214.001 at 004 par. 9. 120

1999: 2.4.3, AOPR.0001.216_001 at 216_006 to 216_008 ; 2000, 2.4 .3, AOPR.0008 .2 06 . 121 No version of the questionnaire signed by Gooley was located by those assisting the

Commission. 122 CIV.OO 1.838 at 922. 123

AARA.0568.051; WITS.0214.001 at 012 to 013 par. 49 (the date 29 September 1999 is recorded at 012, however, it is evident that this is a typographical error and should be '20 September 1999'). 124

AARA.0568.049; WITS.0214.001 at 012 to 013 par. 49 125 Gooley raised concerns in relation to provisioning, the management of matters, aggressive accounting practices, the lack of timely management accounting information,

the HSI valuation and the OCAL 1999 loans. 126 WITS.0214.001 at 013 par. 50. 127

ANDR.0008.014; ANDR.0008.015; ANDR.0008 .025; ANDR.0008.026; ANDR.0008.016 ; ANDR.0008.019; ANDR.0008.020; ANDR.0008.027; ANDR.0008.029. 128

ANDR.0008.020; ANDR.0008.027. 129 CIV.001.838 at 922. 130

ANDR.0008.029. 131 The Arthur Andersen Audit. 132

AARA.0568.051; WITS .0214.001 at 012 to 013 par. 49. 133 AARA.0568.049; WITS .0214.001 at 012 to 013 pars 49 to 50. 134

1999 : 2.4.2, AOPR.0001.216_002; 2000, 2.4.2, AOPR.0008 .202.

174 Th e audit fun ction

135

See also par. 17 of AUS 206, par. 51 of AUP 32 and par. 13 of APS 4. 136 AARA.0568.051; WITS .0214.001 at 012 to 013 pars 49 to 50; AARA.0568.049. 137

CIV.001.838 at 922- Davies gave evidence that the 1999 auditors' report was issued in around mid to late September 1999: WITS.0241.001 at 005 par. 21. 138 1999: 2.4.1, AOPR.0001.216_001; 2000:2.4.1, AOPR.0008.201.

139

1999: 2.4.4, AOPR.0001.216_009; 2000: 2.4.4, AOPR.0008.208 . 140 WITS.0241.001 at 005 par. 21. 141

WITS.0222.001 at 002 pars 12 to 14 . 142 1999: 2.4 .3, AOPR.0001.216_006; 2000, 2.4 .3, AOPR.0008.206. 143

Jackson signed one version of the audit review questionnaire (completed by Buttle and Pye) on 16 October 2000 (AND.l674.0001.0572 at 0577). Another version of the questionnaire (completed by Pye and Fanning) was not signed by Jackson as having been reviewed (AND.l672.0005.0425 at 0430). 144

T17309/l6 to T17309/l8. 145 T1731 0/28 to T173l0/49. 146

AND.1674.000 1.0572 at 0576. 147 WITS .0222.001 at 006 par. 42 ; T17305/57 to T17306/17. 14 8

T17554/51 to T17554/54. 149 AARA.0568.044. 150

Jackson stated that he had not been formally appointed to the role of concurring partner but thought that he was 'best placed' amongst the various Andersen partners to sign the review and to indicate that the normal representations could be given: WITS.0222.001 at 008 to 009 par. 57; T17305/45 to T17305/52; T1731 0/51 to TI7313/49. 151

AND.l674.0001.0572 at 0577. 152 CIV.001.926 at 999 003. 153

Under Andersen policy, the questionnaire was to be dated as at the date of signing the accounts (or very close to that time) to reflect the situation that existed at that time: T17309/48 to T17309/53 . 154

T17306/30 to T17308/11; T17309/48 to T1731 0/26. 155 T17309/55 to T17309/57. 156

T17306/30 to T17308/l1; T17309/48 to T1731 0/26 (Jackson). 157 1999: 2.4.1, AOPR.0001.216_001; 2000: 2.4.1, AOPR.0008.201. 158

1999: 2.4.4, AOPR.0001.216 _ 009; 2000: 2.4.4, AOPR.0008.208. 159 2000 : 2.4.5.2, AOPR.0008.211 . 160

2000: 2.4.5.3, AOPR.0008 .212 . 16 1 AND.l674.0001.0572 at 0576. 162

With the exception of the SMART documents: see WITS .0222.001 at 006 pars 40 to 41. 163 Such as the engagement partner, second engagement partner and practice director. 164

T17308/23 to T17309/8.

The failure of HIH Insurance 175

165

1999:2.4.5, AOPR.0001.2I7; 2000:2.4.5, AOPR.0008 .209. 166 AND.l392.0008.0342 at 0344; AND.l384.0001.0084 at 0087; AND.l678.0035 .0084 at 0087; AARA.0570.004 at 008; AND.l917.000l.OOOI at 0005 to 0006. 167

See also par. I7 of AUS 206, par. 51 of AUP 32 and par. I3 of APS 4. 168 Issued by the Australian Society of Certified Practising Accountants and the Institute of Chartered Accountants in Australia. 169

AUP 32 par. 9(a). 170 AUP 32 par. 9(b). 171

AUP 32 par. II. 172 WITS.Ol56.00IA at IliA par. 1.6 (Williams). 173

ANDR.0002.100A at liSA; ANDR.0002.183A at 185A and 188A; ANDR.0004.198A at 198A; ANDR.0004.202A at 205A; T17278116 (Knoblanche). 174 CIV.OOI.926 at 995 and CIV.OOI.838 at 911. 175

AND.1421.0001.0264. 176 AND.6016.0218 at 0218. 177

Gardener joined the HIH board in December 1998. 178 WITS.Ol68.00I at 037 par. 104. 179

WITS .Ol68.001 at 006 and 008 pars 3 and 8. 180 WITS .Ol68.00I at 009 par. 12 (Cohen); WITS .OI66.001 at 006 par. 30 (Gardener); WITS.Ol61.001A at 037A to 038A par. 5.9 (Cassidy). 181

COHE.0004.0I4. 182 T14541 /27. 183

T14541127. Gardener gave evidence that his benefit was $40 000 per annum: T13969/30. 184 ANDR.0002.163; ANDR.0002.165; T14540/6. 185

COHE.0004.013; ANDR.0002.163; Tl4538/40. 186 Tl4541/16. 187

T14541132. 188 T14541 /36. 189

Tl4542/4 to Tl4542/5 1. 190 WITS.Ol68.001 at 047 par. I33 (Cohen). 191

WITS .Ol62.00I at 003 par. 2.1.1. 192 WITS.0162.001 at 003 par. 2.1.2. 193

WITS.Ol62.001 at 001 par. 1.3.1. 194 WITS.Ol62.00I at OOI par. 1.3.2. 195

ANDR.0004.2I9at220. 196 WITS.OI31.001 at OI2 par. C6 (Simpson); T12897/5I (Fodera). 197

WITS.OI66.001 at 007 pars 39 and 42. 198 WITS.OI66.00I at 008 par. 45.

176 The audit function

199

WITS .0166.001 at 001 par. 3. 200 WITS.0166.001 at 003 par. 15 . 201

WITS.0166.001 at 002 par. 8. 202 WITS .0166.001 at 002 par. 10. 203

ANDR.0003. 173 at 174. 204 WITS.0168.001 at 009 par. 12 (Cohen); WITS.0166.001 at 006 par. 30 (Gardener); WITS.0161.001A at 037A to 038A par. 5.9 (Cassidy). 205

Tl396911 6 to Tl3969/3 0. 206 Tl1861112 (Williams); WITS.0179.001 at 005 par. 7 (Abbott); WITS.0168.001 at 030 pars 77 to 78 (Cohen); WITS.Ol70.001 at 009 par. 27 (Gorrie); WITS .0189.001 at 048

par. 158 (Stitt). 207 Tl7360/51 to Tl7361/48. 208

AND.6183 .0004; WITS.0214.001 at 007 par. 23 (Gooley). 209 Tl3964/12 to Tl3965/23. 210

AUDC.Ol2.001; AUDC.013.001; AUDC.014.001 ; AUDC.015.001; AUDC.016.001; AUDC.017.00 1; AUDC .018.001 ; AUDC.019.001. 2 11 WITS .0168 .001 at 037 par. 106 (Cohen); WITS .Ol70.001 at 010 par. 29 (Gorrie);

WITS .0189.001 at 040 par. 133 (Stitt); WITS.Ol66.001 at 008 par. 47 (Gardener). 212 AND.1386.0008 .0173 ; Tl7403/10 to Tl7403/20 (Davies); T9993/19 (Simpson); Tl6665/51 (Pye); WITS.0067.001 at 003 par. 16 (Buttle); WITS.0064.001 at 006 par.

35 (Pye). 213 T17407/4toT17407/ll. 214

See AUS 710 par. 25. 215 Held before each audit committee meeting in the absence of Andersen: Tl6808 (Pye). 216

WITS.0189.188 at 201. 217 Committee on the Financial Aspects of Corporate Governance (UK, December 1992) par. 4.35(c). 218

Tl6808. 219 Tl7057 /3 to Tl7057 /13 . 220

AND.1392.0008.0342 at 0343 ; AND .l384.0001.0084 at 0086; AND.l678.0035.0084 at 0086; AARA.0570.004 at 006; AND .1917.0001.0001 at 0004. 221 AND.l392.0008 .0342 at 0343 ; AND .1384.0001.0084 at 0085; AND.l678.0035.0084 at

0085 ; AARA.0570.004 at 006; AND.l917.0001.0001 at 0003 . 222 Tl7036/36. 223

Tl7402/20 (Davies); Tl6664114 (Pye). 224 Tl4557/2 to Tl4558/6 (Cohen). 225

AUDC.013 .096; see also AARA.0568.244, AND.l386.0008.0298. 226 AUDC.Ol3 .096 at 099. 227

T4485/19 to T4485/21; T4486/ 13 to T4486/23; T4486/55 to T4486/57; Tl7403/40. 228 AARA.0568.244; AND.1386.0008.0298 (version with Gooley's comments).

The failure ofHIH Insurance 177

229

Tl1853/46 to Tl1854/6. 230 WITS .0156.001A at 177A to 178Apar. 11. 231

Tl2892/51 to T12893/ 18 . 232 TJ6805/35. 233

T4187/23 . 23 4 WITS .0191.001 at 003 par. 9. 235

T 14548/44. 236 AND.60 16.0218. 237

T I 7522/41 to Tl7522/52; Tl7528/30 (Davies). 238 Tl1854/ 13. 239

T 17528/3 2 to Tl7528/52. 240 WITS .0216.001 at 008 par. 26. 241

T17522/41 to Tl7522/52; Tl7528/30. 242 The meeting was held on the same day that Andersen had announced to their partners that Buttle was joining the firm: ANDR.0002.139. 243

WITS.0156.001A at 178Apar. 11 (Williams). 244 T I 7070/36 to Tl7070/42 ; see also AARA.0362.0066. 245

AARA.0106.0001 at 0015 ; CIV .001.926 at 999 _003. 246 T4485 /32 to T4485/3 3. 247

T4383/49 to T4383/58. 248 Tl6796/42; Tl6797/34 to Tl6797/36; Tl6805/9 to Tl6805/ 12. 249

WITS.0266.001 at 006 par. 11A. 250 WITS .OJ56 .001A at 177A to 178A par. 11. 251

WITS.0216.001 at 009 par. 32. 252 WITS .0266.001 at 006 par. 11A. 253

WITS .0216.001 at 008 par. 25. 254 AND.6016.0218; Tl7522/2 to Tl7522112; Tl7522/29 to Tl7522/52 (Davies). 255

Tl6784/ 13, Tl6791/7, Tl6792/43. 256 Tl6797/54 to Tl6797/57. 257

Tl6792/21 to Tl6792/22. 258 AARA.0568.03 2 at 033 . 259

Tl6791/5 to Tl679119. 260 Tl4557/2 to T14558/6 (Cohen). 26 1

ANDR.0004.198A at 198A. 262 AND.6016.0218. 263

Tl7369/2 to Tl7369/27 (Davies); Tl7275/54 to Tl7277/14 (Knoblanche); Tl7303/8 to Tl7304/28 (Jackson). 264 Tl6804/21.

178 Th e auditfonction

265

T 16796/28. 266 Tl680l/32 to Tl680l/38. 267

Tl6802/3 2 to Tl6802/3 8. 268 Tl6803/l2. 269

Tl6803/53, Tl6804/l5. 270 AARA.0568.032 at 033 . 27 1

Tl6787/45 . 272 Tl6789/42 . 273

Background paper entitled 'Australian Auditing Standards' (tendered at T18585/35 to Tl8585/51 ), pars 46 to 49, 123 to 132. 274 AUS 208 par. 02. 275

AUS 208 par. 05. 276 AUS 208 par. 06. 277

AUS 502 par. 02. 278 AUS 502 par. 10. 279

AUS 502 par. 12 . 280 AUS 502 par. 18 . 281

AUS 502 par. 07 . 28 2 Tl8485 to Tl8584. 283

Tl8544/7 to Tl8544/43. 284 AASB 1020 par. 06. 285

AASB 1020 par. 12 . 286 AASB 1020 par. 13. 287

PN 36 par. 7. 288 PN 36 pars 9 to 14 . 289

AASB 1020 par. 20. 29 ° CIV.001.838 at 893; CIV.001.926 at 972 . 29 1

SBB .016.405_001; SBB .016.406_001. 292 In particular AA.0002.0001.0145 at 0146. 293

WITS.0249.001 at 019 to 025 pars 3.21 to 3.37. 294 CIV.001.926 at 972. 295

AASB 1020 par. 20. 296 AND.1387.0033 .0001 ; AND.1387.0033 .0005 ; AND.1387 .0033.0006; AND.l387.0033.0007 ; AND.l387.0033.0011 ; AND.1387 .0033 .0018;

AND.1387 .0033 .0020; AND.1387.0033.0021; AND.1387 .0033 .0023 ; AND.1387.0033 .0026; AND.5405.0002; AND.1387.0012.0001; Tl6849/27 to Tl6850/36 (Pye); Tl7561/54 to Tl7562/l7 (Davies). 297

WITS.0249.001 at 014 to 018 051 to 052 pars 3.18 to 3.20. 298 Tl6861/12 to Tl6861/29.

The failure of H/H Insurance 179

299

Tl7561 /54toTI7562117. 300 See WITS .0249.001 at 014 to 018 and 051 to 052 pars 3.18 to 3.20 (Couttas). 30 1

AND.l672.0029.0034. 302 AND.1668.0007.00 17 ; AND.1668 .0006.0028; AND.1668.0007.0084; AND.1672.0006.0024; AND .1672.0029.0008; AND.l672.0021.0382;

AND .I668.0007.0033 ; AND.l672.0021.0387; AND.I668.0006.0097; AND.1668. 0007.0089; AND.l668.0008.0152. 303 AND.l668.0007.0017; AND.l668.0006.0028 ; AND.1668 .0007 .0084;

AND.1672.0006.0024; AND.1672.0029.0008; AND.1672.0021.0382; AND.l668.0007.0033; AND.l672.0021.0387; AND.l668.0007.0089; AND.l668.0008.0152 ; AND.l672.0007.0122; AND.1672.0007.0121 ; AND.l672.0007.0472. 304

AND.l668.0006.0097. 305 AUDC.017.031 ; Tl6874/32 to Tl6877/8 (Pye). 306

AUDC.018.001 ; ABB.0 120.017 at 01 9; AA.0004.0001.0240 at 0240. 307 AA.0004.0001 .0240 at 0240. 308

AND.l668.0003.0001 at 0003 . 309 AND.l672.0029.0034 at 0038 to 0040; Tl6866/5 to Tl6867/9 (Pye). 3 10

Tl7136/23 to Tl7136/41 (Butt1e) ; WITS.015 2.001 at 005 to 006 pars 29 to 32 (Abela); Tl1500/41 to Til 50119 (Abela). 3 11 AND .1672.0029.0001; AND .1672.0029.0004; AND.1672.0029.0006. 3 12

Andersen signed the audit report in respect of the 2000 financial report on 16 October 2000 (CIV.001.926 at 999 _003). 3 13 AND.1672.0029.0027; AND.l672.0029.0029; AND.1672.0029.0031 ; WITS .0152.001

at 006 par. 32. 3 14 AND .1672.0029.0004. 3 15

AND.1672.0030.0006; AND.1672.0030.0008 ; AND.1672.0030.0012; AND .1672.0030.0022; AND.1672.0030.0023 . 316 The requirements of AUS 520 are discussed in the section of this chapter dealing with

deferred information technology costs. 317 WITS .0249.001 at 025 to 050 pars 3.38 to 3.75. 3 18

WITS .0249.001 at 035 to 036 pars 3.54 to 3.55. 3 19 WITS .0249.001 at 036 par. 3.55 . 320

WITS .0249.001 at 036 to 037 par. 3.55. 32 1 WITS .0249.001 at 036 to 037 par. 3.55 . 322

WITS.0249.001 at 038 and 041 pars 3.55 and 3.60. 323 WITS.0249.001 at 041 par. 3.60. 324

Tl1509/58 to Tl1510/3. 325 AND.6204.0001.0084. 326

AND.6204.0001.0084 at 0087.

180 Th e audit function

327

AND .l671.0008.0009 at 0010. 328 AARA.0570.004 at 0010; AND.1705.0001.0157; AND.6028.0015 . 329

WITS .0249.001 at 047 to 050 par. 3.74 . 330 Tl7142/33toT17142/36. 33 1

WITS .0249.00 1 at 009 to 014, 019 to 025 and 051 pars 3.4 to 3.17 and 3.21 to 3.37. 332 AND.1672.0029.0001; AND.1672 .0007.0322; AND.1668.0007.0033; AND.1672.0029.0034. 333

Tl1494/28 to Tl1494/39 . 334 T11494/45 to Tll494/58 . 335

Tl6855/29 to Tl6855/36. 336 T 16853/49 to Tl6853/56. 337

SBB.016.405_001; SBB.016.406_001. 338 In particular AA.0002.0001.0145 at 0146. 339

SBB.OI6.405_001; SBB.016.406_001. 340 AASB 1023 pars 10.4 and 1 0.5. 34 1

AASB ! 023 par. 10 .5. 342 CIY.001.838 at 876; CIV.001 .926 at 952 . 343

CIV.001.838 at 879; CIY .001.926 at 955. 344 AND.1387.0023 .0095 ; AND.1685.0001.0112 at 0113 and 0114. 345

AND.5010.0102 at 0131 and 0132; AND .6118.0088; AND.6118.0090; AND.6124.0097; AND.6124.0085. 346 AND.I387.0023 .0093 ; AND.1411.0002.0461; AND.1387.0023.0095 ;

AND.1387.0023.0097; AND.l387.0031.0208 at 0213; AND.1685 .0001.0112. 347 Tl3366/13 to Tl3367118. 348

T13367/20 to Tl3367/27 . 349 Tl3367/43 to Tl3367/49. 35 0

Tl3368/3 to Tl3368/9. 351 Tl6472/36 to Tl6472/42. 352

WITS.0164.001 at 013 par. 41. 353 WITS.0164.001 at 013 par. 41. 354

Tl5867/54 to Tl5868/2. 355 Tl5868115 to Tl5868/18. 356

WITS.0041.001 at 001 par. 4 (Simpson). 357 Tl6887 /58 to Tl6888/3. 358

AND.I387.0031.0191 at0191. 359 AND.1685 .0001.0112; AND.1685.0001.0117; AND.1685.0001.0118; AND.1685.0001.0119; AND.1685.0001.0120; AND.l685.0001.0121;

AND.1685 .0001.0122; AND.1685 .0001.0123; AND.1685 .0001.0124; AND.1685.0001.0125; AND.1685 .0001.0126; AND.1685.0001 .0127 ;

The failure of HIH Insurance 181

AND.l685.0001.0128; AND.1685.0001.0129; AND.1685 .0001.0130; AND.l685.0001.0131; AND.1685.0001.0132; AND .1685.0001.0133; AND.l685.0001.0134; AND.l685.0001.0135; AND.1685 .0001.0136; AND.1685.0001.0137; AND.1685 .0001.0138; AND.1685 .0001.0139; AND .I685.000 1.0140; AND.1685.0001.0141; AND.1685 .0001.0142; AND.1685 .0001.0143; AND.1685 .0001.0144; AND.1685.0001.0145 . 360

AND.1685.0001.0112at0112. 361 AND.1685 .0001.0112 at 0112. 362

AND.1685.0001.0112 at0116. 363 WITS .0248.001 at 008 to 010 and 013 pars 4.8 to 4.13 and 6. 364

AUS 502 par. 12 . 365 AUS 502 par. 13(e). 366

SAC 4 pars 14 and 38. 367 SAC 4 par. 4. 368

AUDC .017.031 at 039. 369 AND.1063.0001.1651 ; WITS.0204.078 at 135 137; AUDC.010.118 at 124 and 130; AND.1 026.0046 at 0065 . 370 AND.1359.0008 at 034 and 036; AND.1412.0005.0044 at 0064; AUDC.012.051 ;

AND.1411.0002.0387; AND.1411.0002.0388; AND.1411.0002.0389; AND.1411.0002.0390; AND.1411.0002.0391; AND.1411.0002.0392; AND.l411.0002.0393; AND.1411.0002.0394; AND.1411.0002.0395 ; AND.1411.0002.0396; AND.1411.0002.0397; AND.1411.0002.0398; AND.1411.0002.0399. 37 1

AND. 1386.0002.0012 at 0013 . 372 WITS.0164.001 at 005 and 006 par. 20. 373

AUDC.017.031 at039. 374 AUDC.014.045 at 051. 375

AND.1386.0002.0001 at 0001. 376 WITS.0204.078 at 090. 377

WITS.0164.001 at 005 to 006 par. 20. 378 WITS.0255.001 at 004 and 017 par. 3.3. 379

AUS 502 par. 15. 380 AUS 520 par. 05. 38 1

AUS 520 par. 08. 382 AUS 520 par. 07 . 383

WITS.0255.001 at 016 par. 4.12. 384 AND .l386.0002.0001. 385

AUDC.017.031 at039. 386 AND.1672.0021.0503 at 0503; AND.1668.0007.0017 at 0018; AND.l672.0023.0124; AA.0006.0007.0235; AND.6137.0029 at 0040.

182 The audit function

387

AA.0006.0007.0002 at 0002; AND.6137.0029 at 0040. 388 AND.1672.0027.0004; AA.0006.0007.0002. 389

WITS.0164.001 at 005 to 006 par. 20. 390 AND.1672.0027.0002. 391

AND.1672.0027.0002; AA.0006.0007.0002 at 0003 and 0007. 392 AND.1672.0023.0125; AA.0006.0007.0002 at 0003 and 0007. 393

AND.1672.0041.0001 at 0002. 394 AND.1672.0041.0001 at 0002. 395

WITS.0204.078 at 106. 396 AND.1668.0007 .0017 at 0018; AUDC.017.031 at 032; AND.1672.0007.0121; AND.6137.0029 at 0040. 397

AUDC.Ol7.031 at 045 ; AND.6204.0001.0084 at 0087; AND.1671.0004.0009 at 0010 and 0011. A memorandum to the files from Smith dated 5 October 2000 entitled 'Impact of Contract' (AARA.0572.1 03 at 1 04; AND.1671 .0004.0034 at 0035) was, however, incomplete as to whether the Allianz transaction provided 'support for the

intangible balance'. 398 SBA.150.897 001 at 897 051. - -399

WITS.0204.004 at 027 to 028. 400 AND .l671.0004.0009; AND.1671.0004.0034; AND.6204.0001.0084. 401

WITS.0255.001 at 011 to 012 par. 3.23. 402 AND.1672.0023.0125. 403

AND.1672.0027 .0004. 404 AASB 1031 pars 4.1, 4.1.4 and 4.1.6. 405

$29.5 million after amortisation: CIV.001.690 at 739. 406 $42.1 million after amortisation: CIV.001.764 at 813 . 407

$70 million after amortisation: AND.1411.0002.0242 and BRD.048.114 at 151. 408 AASB 1013 par. 13 .1. 409

AASB 1013 par. 5.1. 41 0 AASB 1013 par. 5.1.3 . 41 1

AASB 1013 par. 5.4. 412 AASB 1013 par. 5.5. 413

AASB 1013 par. 5.6. 414 AASB 1013 par. 5.7. 415

AASB 1013 par. 5.8. 416 AASB 1013 par. 7.1. 417

SIMP.0002.354. 418 GENL.0002.001 . 419

AARA.0217 .008l. 420 AARA.0217.0081 at0083.

The failure of HJH Insurance 183

421

AARA.0216.0010. 422 AARA.0216.00 1 0. 423

SBB.057.688_001 at 688_ 141 , 688_ 197 and 688_204. 424 BRD.059.071 at 097. 425

ADLE.0004.266 . 426 AA.0001.0001.0174. 427

AA.0001.0001.0174 at 0182 to 0183. 428 AA.0001.0001.0174 at 0188 . 429

AND.1671.0008 .0173 at0179. 430 ARCH.0001.119. 431

AUDC.017.001 at 002 . 432 AA.0006.0001.0071. 433

AA.0006.0001.0071 at 0071. 434 AARA.0217.0081. 435

BKEM.0016.059; BKEM.0016.060 at 065 . 436 SIMP.0002.367 at 368. 437

AARA.0217.0081 at 0081. 438 AND.1387.00 16.001 8. 439

WITS.0212.003 at 017 . 440 TI3312/3 (Fodera). 441

WITS.0263.001 at 013 to 016 ; Tl8490/ 13 to Tl8490/31 ; WITS.0285 .001 at 001 pars 1 to 3. 442 CIV.001.027 at 034 to 038 ati.d 048 to 049 . 443

AARA.0217.0081. 444 SBB.020.367_001 at367_003; TEND.0004.007. 445

TI3335/ 12 to T13335/34 (Fodera); Tl6901/48 to TI6901/52 (Pye). 446 AARA.0123 .0016. 447

AARA.0217.0081 at0083. 448 AARA.0217.0126. 449

AARC.0002.060. 450 AARC.0002.060 at 061. 451

AARA.0216.0010. 452 AND.l387.0016.0001 ; AARA.0216.0010. 453

WITS.0263.001 at 041 to 042 par. 5.14 . 454 Tl8500/37. 455

CIV.001.027 at 035. 456 T 18500/23. 457

SBB.003.472 001.

184 The audit function

458

Tl8500/23. 459 WITS .0212.003 at 064. 460

Andersen made no direct submission in response. 46 1 See also WITS .0263 .001 at 035 to 036 par. 4.6 (Couttas). 462

SBB.003.472_001 ; SBB .003.473_001 ; SBB.003.474_001 ; SBB.003.475_001 ; SBB.003.476 001. 463 SBB.003.473 001. 464

AARA.0216.0010. 465 WITS.0263 .001 at 041 par. 5.1 4. 466

Tl8499119 to Tl8499/22 . 467 WITS.0204.004 at 045 . 468

WITS .0212.003 at 053 to 054. 469 WITS .0212.003 at 060 and 061. 470

WITS.0263 .001 at 029 par. 3.65 . 47 1 WITS .0263 .001 at 030 pars 3.69 to 3.70 . 472

WITS.0263.001 at 029 to 030 pars 3.68 to 3.72. 473 Tl8511!14toT18511/26. 474

WITS .0212.003 at 055 to 056. 475 AND.l672.0024.0011. 476

AUDC.Ol7 .031 at 045 . 477 WITS .0212.003 at 062 . 478

See also Tl6920/46 to Tl6920/49 (Pye). 479 See the audit committee minutes (AUDC.Ol7.001 at 002) and the draft accounts (AND.l670.0004.000 1 ). 48 0

Tl 7 122/17. 48 1 WITS.0263.001 at 052 pars 5.39 to 5.42. 482

ARCH.0001.119. 483 CIV.001.926 at 999 003 . 484

WITS.0212.003 at 045 ; see AA.0001.0001.0174 at 0188. 485 ARCH.0001.119. 486

AND.l671.0008.0096. 487 WITS.0204.004 at 031. 488

AND.6204.0001.0084. 489 WITS.0204.004 at 032 . 490

WITS.0204.004 at 036. 49 1 AND.6204.0001.0084. 492

WITS .0256.001 at 048 par. 2.66.

Th e of HJH Insurance 185

493

AARA.0603 .030A; AARA.0603 .042A; AARA.0603.021 ; AARA.Ol40.0004; AARA.Ol39.0004; AND.l413.0001.0310; AARA.Ol38 .0004; AARA.0603.006A ; AARA.O 127.00 19; AND.4090.0 187. 494

AND.l917.0001.0001 at 0008. 495 AARA.0570.004 at 010. 496

AND.l705.0001.0157 at 0157; AND.6028 .0015 at 0015. 497 AND.l671.0008.0009at0010. 498

ARCH.0001.119. 499 CORE.Oll.087 at 112. 500

Tl8432/45 to Tl8432/50. 501 Tl8433111 to Tl8433/ 16. 502

AND.6011.0075 at 0077. 503 Tl8434115 to Tl8434/36. 504

T18434/36 to Tl8434/47. 505 Tl8435/23 (Fodera). 506

Tl8435/36 to Tl8435/39 . 507 Tl8436/5 to Tl8436/9. 508

CORE.Oll.087 at 109. 509 CORE.Oll.087 at 110. 5 10

Tl8438/3 to Tl8438/7. 5 11 Tl8438/21. 5 12

Core earnings from FAI retail portfolios for the year ended 30 June 2000 were $59.47 million: BDWL.0002.004 at 006. Core earnings from FAI Australian businesses for the year ended 30 June 2000 were $36.9 million : BRD.059.071 at 076. 5 13

SBA.l71.710 001 at009. 5 14 ARCH.0001.119. 5 15

Tl8438/21. 5 16 ARCH.0001.119. 517

The FAI goodwill still had 19 years over which the total would be amortised, so any multiple less than 19 would have indicated that profits were sufficient to cover the amortisation. 5 18

ARCH.0001.119. 5 19 Particularly the copy of the Fodera presentation given to Pye which included his notes on the relevant forecast: AND.l671.0008.0173 . The detail of his assessment is found in

the 9 October 2000 memorandum: AND.6204.0001.0084. 520 ARCH.0001.119. 52 1

GENL.0002.001 at 002. 522 AA.0006.0001.0071 at 0071.

186 Th e audit function

523

AASB 1031, pars 4.1, 4.1.4, 4.1.6; $23.9 million represents 43% ofHIH' s operating profit before income tax for the year ended 30 June 2000 ($55.9 million): CIV.001.926 at 951. 524

AASB I 00 I par. 7 .1. 525 AASB 1001 pars 7.1 and 7.1.3. 526

AASB 1 001 par. 7 .1.1. 527 AASB 1001 par. 8.2. 528

AUS 708 par. 03 . 529 AUS 708 par. 04. 530

AUS 708 par. 10. 531 AUS 708 par. 17 . 532

AUS 708 par. 19. 533 AUS 708 par. 20. 534

AUS 708 par. 22. 535 That is, the going concern questions are not satisfactorily resolved. 536

AUS 708 pars 29 to 33. 537 AUS 708 par. 30. 538

The risk indicators identified were adverse trends and ratios, internal difficulties and aggressive accounting. 539 AND.1384.0001.0138. 540

AND.1384.0001.0142. 541 WITS.0256.001 at 008 to 015 and 055 pars 2.13 to 2.19. 542

AUS 708 par. 19. 543 AUS 708 par. 22. 544

AUS 708 par. 17. 545 WITS.0204.004 at 021 and 043. 546

AND.1672.0007.0121. 547 AND.l671.0008.0001; see also AARA.0572.029; AND.1671.0008.0082. 548

AND.1671.0008.0001 at 0003 to 0004. 549 AND.l671.0008.0001 at 0005 and 0007. 55 0

WITS.0204.004 at 025 to 027. 55 1 AND.l671.0008.0009 at 0009; see also WITS.0204.004 at 072 and T17026/9 (Pye). 552

AND.1671.0008.0009. 553 WITS.0204.004 at 035 and 050 to 051. 554

AND.l671.0008.0009. 555 AARA.0572.078; AND.1671.0004.0009. 556

AARA.0572.103; AND.1671.0004.0034. 557 The text in italics is a handwritten annotation.

Th e f ailure ofHIH Insurance 187

558

AND .1 671.0008.0096. 559 WITS .0204.004 at 031. 560

AND.6204.0001.0084. 56 1 WITS .0204.004 at 031 to 032 . 562

AND.6204.0001.0084. 563 AND.1671 .0008.0009. 564

WITS.0204.004 at 028 to 029 . 565 AND.6204.000 1.0084. 566

AND.l671.0008.0009. 567 AND.6204.000 1.0084. 568

AND.1671.0008.0001 at 0003. 569 WITS .0204.004 at 065 . 570

WITS .0204.004 at 065. 57 1 WITS.0204.004 at 068; see also Tl7035/32 (Pye). 572

T 17 163111 (Pye); T17034/8 to Tl7034/11 (Pye); AA.OOO 1.0001.0174 at 0 188 ; AND.6204.000 1.0084; AND.1671.0004.0034; AARA.0572.078; AND.6006.0 14 7 at 150; AND.1670.0004.0001. 573

WITS .0204.004 at 068; see also Tl7035/32 (Pye). 574 WITS .0204.004 at 068 . 575

This was said by Andersen to be demonstrated in document AND.I947.0003.0330: the list of 29 assumptions that were used to underpin the cash flow forecast that was provided to Andersen in December 2000. 576

Joint venture agreement clauses 12 .5, 12 .6 and 12.9 : AARA.0072.0004 at 0017. 577 Joint venture agreement clause 13.1 : AARA.0072.0004 at 0018. 578

Joint venture agreement clause 13.10: AARA.0072.0004 at 0019. 579 Joint venture agreement clause 13.7: AARA.0072.0004 at 0019. 580

WITS.0256.001 at 037 to 038 pars 2.51 to 2.52 (Couttas). 58 1 WITS.0204.004 at 036. The memorandum entitled 'HIH Going Concern Memoranda' prepared by Pye in April2001 (AND.1671.0008.0009) suggests that limited reliance

was placed upon this presentation in the going concern assessment. 582 AND.6204.000 1.0084. 583

WITS.0256.001 at 047 to 049 pars 2.65 to 2.67 . 584 See AARA.0603.030A; AARA.0603 .042A; AARA.0603 .021 ; AARA.0140.0004; AARA.Ol39.0004; AND.1413 .0001.0310; AARA.0138.0004; AARA.0603 .006A;

AARA.0127.0019; AND.4090.0187; AND.4090.0218; AND.4090.0219; AND.4090.0221; AND.4090.0222; AND.4090.0224. 585 AND.1917.0001.0001 at0008. 586

AARA.0570.004 at 010. 587 AND.l705.0001.0157 at0157. 588

AUS 708, par. 30 .

188 The audit function

589

AND.l671.0008.0009 at 0010. 59 ° CIV.001.926 at 999. 591

See also WITS .0256.001 at 054 par. 2.75 (Couttas). 592 AUP 32 par. 9(a). 593

Save for one meeting after the conclusion of the 2000 audit in relation to the Pacific Eagle Equities transaction. 594 T16784/13, T16791 /7 and T16792/43 (Pye). 595

T16808 (Pye). 596 AND.l392.0008.0342 at 0343 ; AND.1384.0001.0084 at 0086; AND.l678.0035.0084 at 0086; AARA.0570.004 at 006; AND.l917.0001.0001 at 0004. 597

T 17036/22 to /48 (Pye ). 598 T17 402/20 (Davies); T16664/ 14 (Pye) 599

AUP 32 par. 9(a). 600 As was required by auditing standards: AUS 520 par. 07 ; AUS 502 pars 013 and 014.

Th e failure of HIH Insurance 189

22 Home Security International: a case study

Following the takeover of F AI, HIH inherited a 36 per cent shareholding in a company incorporated in Delaware and flo ated on the US stock market known as Home Security International (HSI). HSI conducted a home security business in Australia via its wholly owned subsidiary FAI Home Security Pty Ltd (FAIHS). For various periods of time up until the float of HSI in July 1997 F AIHS was part of the F AI group. After that time it was not. It used the name 'F AI' under a licence agreement with the FAI Insurance Group. HSI's chief executive was Bradley Cooper.

The Commission received a considerable amount of evidence concerning HIH's 'management' of its investment in HSI from the time of the takeover until it sold its shareholding to Cooper in December 2000 and then its handling of various claims Cooper made in the period December 2000 to March 2001. I have summarised below the combined losses to HIH from these events. In broad terms there was a loss of value on the 'asset' acquired on takeover of approximately $38 million with a further $4 7 million in cash being handed over for little or no benefit. This may not sound much when the estimated deficiency of HIH may be as high as $5.3 billion. But it was a significant loss to the HIH group coming, as it did, at a crucial time. More importantly I consider that HIH's handling of these issues illustrate a number of endemic problems within HIH in this period including that:

• senior management of HIH, particularly Ray Williams, were unable to formulate a clear and consistent strategy for managing an investment or line of business

• there was a lack of accountability on the part of senior management, particularly Williams, for the poor decisions they made

• there was no disclosure to the board of HIH of significant transactions and when such disclosure did occur it was after the event such that the board had no input into the decision-making process and

• in the last few months ofHIH's corporate life, there was a complete breakdown of accountability within the organisation at a senior level.

To explain this and to do fairness to those who were involved it is necessary to set out the evidence of these events in some detail. At the outset I emphasise that although they feature in a number of the transactions, neither Cooper nor Paul Brown was an officer or employee of HIH or F AI nor was HSI or F AIHS part of the HIH

group at any relevant time for the purposes of my inquiry. As such they are not

The failure ofHIH Insurance 191

central to my inquiry except to the extent that their conduct and activities reflect on the effectiveness of HIH's management and its corporate governance mechanisms. They provide an insight into much of what was wrong within HIH. This is why it is referred to as a 'case study'.

22.1 HSI prior to the takeover

HSI's annual Securities and Exchange Commission (SEC) return for the financial year ending 30 June 1999 described HSI's business as being a direct sales company which sold, installed and serviced residential security alarm systems under the name 'SecurityGuard' through a distributor network. HSI conducted its business principally in Australia and New Zealand but it also had operations in Europe, South Africa and North America.' The return also contained the following description of the history of the company: -

The Company was founded by Bradley D. Cooper and commenced business in Sydney, Australia in 1988 ...

In 1990, 50% of the Company was sold to F AI Insurances Limited ("F AI Insurances") and the remaining 50% was sold to F AI Insurances in a series of transactions during 1994 and 1995. In November 1995, FAI Insurances sold the home security operations of the Company outside Australia and New Zealand to Bradley Cooper. On March 31, 1997, FAI Insurances reacquired the business and substantially all of the assets of the international operations from Mr Cooper. Thereafter, on June 30, 1997, the Company completed a reorganization, and thereby began operations as a Delaware corporation. Following its reorganization, in July 1997 the Company completed its initial public offering (IP0).2

The listing price for HSI shares for the IPO was US$1 0. 3 Initially F AI retained a 45 per cent equity interest. 4 Between mid-1997 and late 1998 it sold down to a 36 per cent shareholding.

22.1.1 FFC purchase

On 31 December 1997 HSI purchased 50 per cent of the issued shares of F AI Finance Corporation (FPC) from FAI Insurances. The purchase price of A$10.75 million was financed by the issuing of a five-year promissory note in favour ofFAl Insurances secured over the shares in FPC ('the FPC note'). 5 HSI also acquired an option to purchase the remaining 50 per cent of FPC. 6 FPC was a consumer and business finance company specialising in the provision of consumer credit primarily for the purchase of HSI's SecurityGuard system. 7 It seemed that FPC's principal source of funds was a 'receivable purchase agreement' with W estpac. Pursuant to that agreement FPC sold receivables from customers to W estpac and undertook to continue to service the receivables in exchange for a management fee. The arrangement was described as providing Westpac with one third of all interest collected by FPC in exchange for providing FPC with funds. 8 FAI Insurances guaranteed Westpac's exposure under this agreement.

192 Home Security International: a case study

22.1.2 Ness

Prior to 1995 F AI Home Security (as it then was) acquired all of its SecurityGuard alarms from Westinghouse Brake and Signal Company (Australia) Limited which was a member of the BTR Nylex Group. In September 1995 Ness Security Products Pty Ltd (Ness) completed a buyout of the business of manufacturing, assembling and sale of the security alarms from Westinghouse. 9 At the time of acquisition, the shareholding in Ness was comprised as follows : 24.96 per cent of the shares were allocated to Circosta Pty Limited, a company associated with the manager Nazareno Circosta, 4 per cent of the shares were allocated to Vanuatu International Trust Company Limited (VITCO), 19 .2 per cent of the shares were allocated to Frenhill Pty Limited, a nominee company ofF AI Home Security 10, and 51.84 per cent was allocated to Integrated International Home Security Limited (IIHSL). 11 IIHSL was incorporated in the British Virgin Islands on 19 September 1995. 12 IIHSL was associated with Brown, a resident of Monaco and a friend of Rodney Adler. In July

1998 Brown advised Landerer, that he was the beneficial owner of all the shares in IIHSL. 13 Between 1995 and 1998 IIHSL acquired further shares such that by 30 June 1998 it had acquired 75.04 per cent of all the shares ofNess. The remainder were held by Circosta Pty Limited.

In the middle of 1998 there was a substantial debate within the board ofF AI (as the largest individual shareholder in HSI) concerning a proposal for HSI to purchase IIHSL's shareholding in Ness. The board voted to 'approve' the transaction (although strictly speaking it was a matter for the HSI board). By an agreement dated 17 July 1998 14, which was amended in September 1998 15, one of Brown's companies, Integral Investments Limited (Integral), agreed to sell to HSI all of the shares in IIHSL for an aggregate purchase price of A$25.4 million. The purchase price comprised 400 000 shares of 'common stock' in 'HSI', a five-year convertible warrant to purchase 360 000 shares of common stock at an execution price of US$13 million 16, US$2.426 million in cash and a promissory note in favour of Integral (the Ness note). The Ness note secured the repayment ofUS$9.098 million, payable in instalments ofUS$400 000 on 30 June 1999 and 31 December 1999 with the balance due on 30 June 2000. 17

As at the date of this sale, IIHSL held 781 666 shares in Ness. Brown paid approximately A$830 000 between 1995 and 1998 for shares in Ness. 18 He sold them for just over $25 million. Whether he could obtain all of his money depended on whether HSI could pay out the Ness note.

22.1.3 1998 Share price spike

Throughout 1998 the share price of HSI gradually decreased. In the days leading up to 26 June 1998 there was little or no trading in HSI shares. However on Friday 26 June 1998 there were 18 000 shares traded, on Monday 29 June 1998 there were 18 500 shares traded and on 30 June 1998 there were 30 500 shares traded. There was a corresponding spike in the price ofHSI shares. It increased from $US10.75 on 26 June 1998 19 to a peak ofUS$13.88 on 30 June 1998?0

The failure of HIH Insurance 193

For the year ending 30 June 1998 FAI booked the value of its HSI shares at the US$13.88 price. Andersen calculated that the effect of the 'spike' in the price was that FAI were able to 'mark to market' its investment in HSI by approximately A$12 million more than it otherwise could. 21

The circumstances in which the 'spike' occurred are curious and may excite attention in other quarters. The share trading occurred overseas and the Commission obtained limited information about it. I was not able to conclude whether anyone associated with F AI sought to manipulate HSI' s share price.

22.2 HSI from acquisition until April 2000

When HIH completed its takeover of FAI in January 1999, it also acquired approximately 36 per cent22 of the shares in HSI and a 50 per cent shareholding in FFC (the other 50 per cent being held by HSI through F AIHS). By that time Cooper was also a substantial shareholder of HSI and as chief executive officer was drawing a salary of approximately US$700 000. HSI was indebted to HIH (through F AI Insurances) under the FFC note for approximately $10.75 million. HSI had a 75 per cent interest in Ness and shortly afterwards acquired the remaining shareholding from interests associated from Circosta. 23 HSI was also indebted to Brown's company, Integral, under the Ness note.

At 30 June 1998 FAI's shareholding in HSI had been booked at its 'market price' of $49.129 million24 and at 31 December 1998 it was booked at $39.573 million?5 From February to August 1999 HSI's share price dropped from A$10.00 to A$4.00. 26 As at 30 June 1999 the booked value of HIH's shareholding in HSI was $28 .584 million. 27 That value was obtained by valuing the shares according to an

'offer' made by Cooper in late 1998 to buy the shares for US$8.80. If they had been marked to market at 30 June 1999, as they were as at 30 June 1998, then their book value would have been $18 million. 28

HIH inherited shares in HSI which were dropping in price and debts which looked increasingly unrecoverable. It posed a management test for HIH.

22.2.1 Williams's strategy-control of FFC

Williams told the Commission that after the takeover of F AI, HSI and FFC were regarded as 'non core assets'. HSI was considered difficult to dispose of and it was accepted that it would take time to sell. 29 In September 1999 Colin Richardson of SG Hambros, HIH's group financial adviser, prepared a document described as a

'due diligence report' concerning FFC. 30 It outlined a number of concerns in relation to FFC, especially its relationship with HSI.

Williams's concerns over HIH's approach to HSI and FFC led to a meeting between Cooper, Richardson and Mark Whittaker from HSI on 13 October 1999.31 Various issues were raised including the poor operating results and poor share price, the

194 Home Security International: a case study

outstanding debt to Brown and the possibility of using FFC to fund an expansion of HSI's business through the introduction of the so-called 'Kirby business'. Richardson set out what he thought were the two choices for HSI. These were either to continue to support Cooper but increase control and involvement or to move to control HSC and 'work out' of the situation in Cooper's absence. 32 Richardson's notes of the meeting describe HIH's exposure to HSI and FFC as $113.94 million. That amount comprised $50.77 million in debts owing by them to HIH, $28.80 million equity in HSI, $13.37 million equity in FFC and $21 million as effective guarantor ofFFC under the Westpac securitisation programme. 33

Williams recalled that, although his overall object was to dispose of the group's shareholding in HSI, he was primarily concerned about HSI and FFC's debt to HIH and especially HIH's exposure to Westpac under the securitisation programme for FFC. In addition HSI had an option to acquire HIH's remaining stake in FFC. 34 If it was exercised HSI could exert complete control over FFC but HIH would underwrite its activities.

Williams's strategy in the period mid-1999 to April 2000 of reducing HIH's debt exposure had two elements. First, in October 1999 HIH acquired a further 10 per cent share holding. 35 This increased its overall shareholding to approximately 47 per cent. This was done to obtain control of HSI. 36

Second, HIH moved to cancel HSI's option to purchase the remaining 50 per cent of FFC. This proved to be expensive. It ultimately resulted in a deal entered into in April 2000 whereby HIH purchased HSI's 50 per cent holding in FFC. It came about as follows.

On 20 October 1999 Cooper wrote to Richardson enclosing three draft 'Heads of Agreement'. 37 The first was a loan agreement whereby HIH would lend HSI the funds to repay the Ness note (to Brown). 38 The second recorded a proposal to grant Cooper an option over HIH's shareholding in HSI. 39 And the third involved HSI cancelling its option over the remaining 50 per cent of FFC in exchange for HIH procuring FFC to fund Kirby and granting an option to Kirby to acquire shares in FFC. 40 Richardson sent Cooper's fax to Williams. 41 There was correspondence concerning this proposal in October and November 1999. 42 Between 29 December

1999 and 31 December 199943 , Cooper and Williams signed an agreement which provided that HSI would cancel its option to purchase the remaining 50 per cent of FFC and HIH would provide US$9 million in loan funds to repay Brown with the facility being repayable over three to five years. The parties agreed to further

discuss the introduction ofthe 'Kirby order flow'. 44 Williams never advised the HIH

board or any of its committees that he had entered into a commitment of $US9 million on behalf of the HIH group.

At some point during February and March 2000 the proposal for HIH to provide finance to HSI to repay Brown in exchange for cancelling the option was transformed. It became a proposal for HIH to purchase the remaining 50 per cent of FFC with the sale proceeds to be used to repay Brown. It is not clear how the

Th e failure of HIH Insurance 195

transaction came to be altered in that way. Richardson recalled that a perception arose that lending ' ... Cooper more money was thought to be fairly unpalatable'. 45

On 17 March 2000 Cooper wrote to Fodera 46 referring to a meeting that occurred on

14 March 2000. He outlined a proposal that included the following:

As you are aware the outstanding debt owing to Paul Brown IS US$8 298 000 which at an exchange rate of 0.6125 equates to A$13 547 755 . There is no dispute that HIH have agreed to lend HSI the full amount required to retire this debt ...

It has been proposed by HIH; that HSI agree to sell back its 50% investment in FAI Finance Company. I would propose to sell this shareholding for $A14 million, payable through a dividend of FFC ' s retained earnings ...

The sale proceeds will be used to pay down the Paul Brown debt and reduce the balance outstanding on the existing FFC Note.

Beside the fact that a purchase price of lower than A$14 million would not be acceptable, there are a number of reasons which support this value including the following :

- HSI's investment in FFC is $A13 ,049,545 . The value would be approximately $471 ,995 higher had FFC's entitlement to the Data Advantage shares being properly accounted for.

- HSI will be able to book a small profit on the transaction.

- The Board of HSI have agreed to support a sale of our interest in FFC for a price no lower than $14 million.

- The terms of the Shareholders Agreement provide HSI with considerable leverage in the event the business plan of FFC is not agreed. As you are aware there are currently a number of contentious issues as to the future direction of FFC.

- HIH will regain 100% control of FFC which currently represents a significant balance sheet exposure to the HIH Group.

- Under the terms of the option formula set out in the Shareholders Agreement the sale price would be A$14,103 ,464.

On 21 March 2000 Richardson wrote to Cooper setting out his understanding of a revised proposal. It involved HIH acquiring HSI's 50 per cent shareholding in FFC for A$12 million. The funds were to be used in full and final settlement of the debt owing to Brown and various other terms applied. Richardson added:

196

As a separate matter, HIH has agreed to sponsor the forthcoming seminars to be produced by Vision in an amount of $1 200 000. Details of this sponsorship will need to be finalised directly with HIH. 47

Home Security International: a case study

The purchase of the remaining 50 per cent of FFC by HIH/ F AI Insurances from HSVF AIRS was effected during April 2000 as follows. Prior to the sale, FAIRS had an outstanding indebtedness of US$4.439 million to HIH/F AI Insurances Limited under the FFC note. 48 Pursuant to a share sale agreement dated 30 March 2000 FAIRS agreed to sell to F AI Insurances Limited its 50 per cent share holding in FFC for A$13.257 million.49 It was a specific condition of the share sale agreement that FAIRS would use the sale proceeds to repay the Ness note to Integral (Brown) .50 However this was not sufficient to completely repay the Ness note and there was still the outstanding indebtedness from FAIRS to F AI Insurances Limited

under the FFC note. Under a refinancing agreement dated 26 April 200051, FAI Insurances Limited agreed to refinance the FFC note and to provide such additional advances as may be required to pay out Brown. 52 FAIRS drew down a further A$531 000 to pay Brown. 53 The result was that after the deal, there was a further debt owing from FAIRS to HIH/F AI Insurances of $7.78 million. 54 It was repayable

in monthly instalments over a five year period. 55 Repayment of this amount was

guaranteed by Ness56 and secured by a fixed and floating charge over Ness' assets57 (the Ness Facility). 58

22.2.2 Other agendas

Counsel assisting submitted that there were various instances of sharp or inappropriate conduct undertaken in this period which were connected to the FFC transaction and that otherwise the individual players had a variety of agendas most of which did not coincide with HIH's best interests. 59 In broad terms I have not been persuaded of the former although I accept the latter. It is necessary to briefly explain why.

22.2.3 Cooper and Adler-acquiring HIH's shareholding

Counsel assisting submitted that throughout the second half of 1999 and at least for a significant period of 2000 both Cooper and Adler had the intention of acquiring and building the business of HSI for their own benefit to the exclusion of HIH. The material referred to included the following.

On 18 May 1999 Adler wrote to Cooper referring to instructions Cooper had given that results were not to be released without Adler's approval. Adler complained that, contrary to that understanding, results had been so released. 60 On 13 August 1999 Adler wrote to Cooper outlining his understanding ofHSI's position and adding:

I suggest that we raise approximately US$3million from the market, offer Paul Brown US$1 million and convert his debt into equity at the same price as the raising. In that way we will substantially change the character and strength of HSI. It will also have the effect of creating a price for

negotiation or comparison with HIH so that they will have more appreciation of the level at which you will eventually take them out . . . 61 [emphasis added]

Th e failure of HIH Insurance 197

Similarly on 3 September 1999 Adler wrote to Cooper 62 in relation to HSI stating the 'we are now moving down a track'. He outlined various elements of the restructuring that HSI was undertaking, sought financial information on HSI and then added:

For the first time I sincerely believe we are at crossroads. We will be a US$500 million company or we will lose a lot money, pull back to Australia and have a moderately successful existence and never achieve what we want to or can at this time.63 [emphasis added]

At the time Adler wrote these letters he was not a director of HSI or a shareholder. 64 When asked about the use of the word 'we' in these letters, Adler said that the correct word should have been 'you' or 'HSI' and it was not meant to signify a joint venture between 'Cooper and himself.65 This is not in accord with the plain meaning of the words used.

Adler continued to correspond with Cooper throughout the period August to December 1999 in relation to Cooper's dealing with HIH. 66 On 16 November 1999 Adler wrote to Cooper saying

It is now time to appoint me to the Board of HIS [sic]. Could you see to the detail. 67

On 8 March 2000 Adler advised Williams that he had become chairman of HSI. In May 2000 Adler and Cooper acquired an 18 per cent shareholding in HSI from an institutional investor in the United States. 68

After the takeover of FAI, Adler's position in relation to HSI and HIH was an ambiguous one. By April 2000 he was both a director of HIH and HSI (and chairman of the latter) and he had corresponded with Cooper in terms that suggested that he and they had designs on the company. Nevertheless to this point I am not satisfied that he improperly involved himself in any transaction involving the two entities.

22.2.4 Cooper's debt factoring

Counsel assisting pointed to certain transactions involving debt factoring arrangements between Cooper and HIH which appeared to be highly favourable to Cooper.

By February 1999 a company known as FAI Home Distributors Pty Limited (Distributors) apparently was indebted to one of Cooper's private companies, Cervale Pty Ltd, for $2 .05 million. 69 Distributors, Cervale and FFC entered into a deed whereby Cervale sold $855 000 of the $2.05 million of debt owed by Distributors to FFC. The deed did not specify the amount paid by FFC but it appears to have been approximately $720 000. 70 The deed required that Distributors pay amounts it collected from its members direct to FFC in discharge of the debt that FFC had purchased from Cervale and that the minimum amount payable per month was $35 625. Cervale and FAIHS guaranteed the repayment to FFC ofthe factored

198 Home Security International: a case study

debt. 71 As part of the security for that guarantee, Cooper provided FFC with a second mortgage over his property at Coronation A venue, Balm oral. On 1 November 1999, Williams wrote to the general manager of FFC, Jeff Jurd, directing him to remove the second mortgage over Cooper's residence. 72 As at

1 November 1999 HIH was in the process of negotiating with Cooper for the relinquishment ofHSI's option to purchase the remaining 50 per cent ofFFC.

Adler advised Williams that Cooper had told him (Adler) that he was 'under financial pressure and he wanted to devote himself to the rebuilding and successful performance of HSI and rather than receive other benefits from HSI, which it could ill afford, he would sooner a release of his mortgage'.

73 Adler also reported Cooper

as having told him that if they wanted HSI to succeed 'then they would have to redress Cooper as an individual, as well as the financial condition of the company' .74 Cooper recalled raising it with Williams and explaining the background and how it was all 'very unfair'. 75 He denied that the discharge of the mortgage was related to any transaction76 and described it as a 'goodwill gesture' .77 Williams described the direction:

as an opportunity to assist us in positioning ourselves with Brad Cooper to achieve our major objective, that of removing the HSI option over FFC ... 78

Williams did not make any inquiries as to the assets that would be available in the event that Cooper defaulted. He assumed that a personal guarantee would be sufficient. 79

Counsel assisting submitted that that this was a private benefit conferred on Cooper as an incentive to pursue the FFC negotiations. Both Williams and Cooper strenuously denied this. While I regard Williams's behaviour in issuing such a direction in an environment where transactions between HIH and HSI were being discussed as troubling, I am not satisfied that it should be characterised in the manner suggested by counsel assisting.

For the sake of completeness I should note that between March and April 2000 Cooper negotiated a deal with HIH whereby Cervale assigned to FFC the remaining $1.15 million of the debt owed by Distributors, it received a payment of $67 5 000 for that debt and it was agreed that Distributors would pay funds direct to FFC and discharge the $1.1 million debt if they had the funds. Cervale guaranteed that obligation. There was no guarantee from Cooper. The end result of both factoring arrangements was that Cooper received over $1.3 million for factoring Distributors' debt and escaped personal liability. However his private company was still guarantor. I will address below how Cervale (later known as the Goodwill Group Pty Ltd) avoided that liability.

The failure ofHJH Insurance 199

22.2.5 Vision Publishing sponsorship

Counsel assisting submitted that Cooper solicited and received a private benefit, being a sponsorship commitment for his company, Vision Publishing, as part of the FFC transaction. It was also submitted that Richardson and Williams agreed to provide that benefit knowing of its connection to the FFC purchase and, in particular, knowing it would encourage Cooper to agree to the purchase price and other terms.

As I have noted already, on 17 March 2000 Cooper wrote to Fodera advising that HSI' s sale price for 50 per cent of FFC was $14 million and that a lower value could not be supported. On 21 March 2000 Richardson wrote to Cooper confirming the purchase price was now A$12 million. 80 Richardson added that 'as a separate matter' HIH had agreed to sponsor Vision in the amount of $1.2 million with the details to be finalised directly with HIH. Cooper denied that the purchase price had been reduced by $2 million as a 'quid pro quo ' for the Vision sponsorship. 81 He said that a proposal for the sponsorship had been first raised in 1999.82 Williams ' s evidence concerning this was as follows:

200

Q. When did the question of the payment of sponsorship funds to Vision Publishing come into these negotiations [concerning the purchase of 50% ofFFC]?

A. That was negotiated with Colin Richardson, with Mr Cooper, and it felt by Mr Richardson that in order to get this transaction completed that it was worthwhile putting entering into or agreeing to enter into that sponsorship.

Q. And was it your understanding that that was something Mr Cooper required.

A. Yes.

Q. In order to encourage HSI to go ahead with the transaction?.

A. Well, that's part of the total transaction, that we would sponsor Vision.

Q. For $1 .2 million dollars?

A. Yes.

Q. So going back to my question, though, Mr Williams, it was something that you understood Mr Cooper required as part of the price .of his support for the transaction.

A. To complete it, Yes. 83

Q. Did it concern you that a director of a company in which HIH was a major shareholder was requiring a personal benefit in order to support a transaction on the part of that company?

A. The whole relationship with HSI worried me, Mr Martin. 84

Home Security International: a case study

Williams provided a supplementary statement in which he referred to this evidence being ' inelegantly phrased'. He said that there was no connection between the Vision Publishing sponsorship and the FFC transaction. 85 In his closing submissions, Richardson provided material by which he sought to demonstrate that there was no reduction in the purchase price but instead the difference in figures was referable to HSI agreeing at the time of the letter of 21 March 2000 to forgo payment of a dividend from FFC, a position that was later reversed when the final purchase price was calculated. 86 Each of Williams, Cooper and Richardson pointed to the fact that the Vision Publishing sponsorship had been the subject of discussions over a significant period including a period that preceded the FFC transaction.

I accept the point made by Richardson that the supposed 'drop' in price for the purchase of 50 per cent of FFC was referrable to the various permutations being considered as to whether a dividend would or would not be paid by FFC. But that is not end of the matter. Williams's answers in his oral evidence appeared quite precise. Nevertheless the documentary material does not suggest an express connection between the two transactions other than a temporal one. The only evidentiary material against Richardson or Cooper expressly suggesting a connection is Williams's concession which he now seeks to retract. His concession is not a sufficient basis for any adverse finding against Richardson or Cooper. Moreover the concession could not be used against Williams in subsequent proceedings. For those reasons I am not minded to take this matter further. While I make no finding of impropriety or dishonesty against any of the individuals involved, I should add that it was inappropriate for Williams to consider such a sponsorship while he was at the same time negotiating a transaction with HSI. To my mind it is axiomatic that pursuing a transaction for the private benefit of the chief executive officer of a company (regardless of whether it is for value or not) while at the same time negotiating a transaction with that company is a course of action fraught with difficulty. Unless appropriate safeguards are in place, including full disclosure to both boards, it should not occur.

22.2.6 The FFC transaction and the repayment of Brown

Throughout the negotiations between HIH and Cooper, it seems to have been accepted that Brown would be paid out with funds provided by HIH. Williams agreed that the amount necessary to repay the Brown debt was the primary driving force of the FFC purchase87 and that the price was otherwise driven by its 'historical value'. 88 However, I accept that the evidence does not enable the conclusion to be drawn that the amount of Brown' s debt was the sole determinant of the price. HSI

had to borrow a further amount ($531 000) beyond the purchase price to pay out the balance of the Brown debt. Although no valuation of FFC was obtained at the time, the material does not support a finding that the sale was at an undervalue.

For an investment in Ness of approximately A$830 000 Brown received a payout of US$11.647 million.89 Ignoring the value of the warrants and shares he received in 1998 and using an exchange rate of A$1 to US$0.60, this represents a cash return of

Th e failure of HIH Insurance 201

A$19.412 million. There was material tendered to the Commission showing that $6.4 million was forwarded from entities associated with Brown to Cooper and $2 million to Adler during 2000. In the case of Adler it seems that in September 2000 Brown agreed to lend him approximately $2 million on an unsecured basis. It was not submitted to me that the evidence suggested any connection between this transaction and any transaction between Brown or one of his companies and either HIH or F AI. I need not consider this matter further.

In the case of Cooper it was submitted to me that I should find that the transaction pursuant to which the amounts were remitted was a quid pro quo for the efforts Cooper made to see Brown paid out. Cooper and his private companies were summonsed to produce all the documents relating to any transaction pursuant to which the $6.4 million may have been paid. $1 .16 million of these funds seems to have been paid by Brown to purchase Cooper's one-third interest in a property development. In relation to the remainder, the material produced revealed that prior to the completion of the FFC transaction on 26 April 2000, Cooper was corresponding with Brown in relation to an 'investment' in Vision90 which ultimately became a deal whereby he invested to obtain rights to participate in a joint venture between Vision and another company, Sales Pursuit. I do not purpose

to analyse the transaction in any detail. Although the transaction seems a very imprudent one for a person of Brown's apparent acumen and experience there is nothing in the documentary material to suggest that it was a 'sham' for the repatriation of funds to Cooper. Nor does the material enable me to be satisfied that Brown entered into the transaction as a direct quid pro quo for Cooper ensuring he was paid out. Brown profited handsomely from his dealings with HIH and F AI and Cooper profited from his dealings with Brown. However neither of them was at any relevant time an employee or officer of HIH or F AI. In the absence of any evidence of impropriety by such a person (or by them) I need not consider this matter any further.

22.3 The Ness acquisition-April 2 000 to September 2000

22. 3.1 The negoti ations

By April 2000 Williams had attained his objective of gaining control of FFC and had the ability to exercise control over HSI. However FFC was still exposed to HSI. Williams told the Commission that he was concerned that if HSI failed it would damage the 'F AI' brand name, and stimulate loan defaults by HSI customers thereby increasing FFC's exposure. 91 Also, HIH's direct indebtedness to HSI had increased as a result of the FFC transaction. Further funds were to be lent. On 8 May 2000 Adler wrote to Dominic Fodera reminding him of HIH's considerable exposure to HSI but advising him that HSI 'will become a cash cow next calendar year'. 92 In the meantime he requested US$3 million 'to survive'.

202 Home Security International: a case study

On 25 May 2000 Adler met Williams and Cooper. It was agreed that HIH would advance a further A$5 million to HSI for nine months secured on the same terms and conditions as the 'Ness facility' .93 In approving those funds, Williams made no inquiry as to whether $5 million was sufficient or whether further funds would be required94, whether they were likely to be repaid or even adequately secured. This loan and the further loans described below were not brought to the board' s attention. It was not apparent how the making of these loans is consistent with any overall strategy for managing HIH' s 'investment' other than one of desperately seeking to

keep it afloat.

During the course of July and August 2000, Adler, Cooper and others from HSI were having discussions with an Israeli based company, Rokonet, concerning Rokonet' s potential investment in either HSI or Ness. By this time Ness was a wholly-owned subsidiary of HSI and F AIHS. On 24 July 2000 Adler advised Williams that he had met with the representative of Rokonet and that it appeared that after a due diligence they would be purchasing 50 per cent of Ness. Adler reminded Williams of the fixed and floating charge over Ness which secured loans of $13 million and how that may be an impediment to any transaction with Rokonet. 95

On 9 August 2000 the board of HSI, including Adler, were given an outline of a possible deal with Rokonet. It involved Rokonet acquiring 51 per cent of Ness and management control for a purchase price of between US$5 .25 mill ion and US $6 million. Rokonet would also have options to acquire further shares in Ness and would subscribe for shares in HSI. 96 They were also advised that the carrying value of Ness in HSI and FAIHS's accounts was A$34.252 million

(US $20.171 million) but that, after consultation with the auditors, it would be written down to US$12 million to reflect Rokonet's offer.

On 14 August 2000 Rokonet sent Cooper a proposal97 offering to pay US$5.25 million for 50 per cent of Ness including management control, US$1 .1 million for 10 per cent of HSI and a requirement that HSI pay an outstanding indebtedness of A$6.4 million to Ness within a year. The proposal was

said to be subject to a due diligence. The debt of A$6.4 million appeared to relate to management charges passing between Ness and HSI. Adler drafted a rep ly for Cooper98 to send to Rokonet which agreed to the purchase price for 50 per cent of Ness but rejected any attempt to adjust management charges. 99 The negotiations with Rokonet did not advance any further. 100

Rokonet was prudent to insist upon management control and the re-adjustment of management fees. Ness' accounts for the financial year ending 30 June 2000 101 included abnormal items of $9.721 million. 102 Approximately $8 million of that amount was management fees and charges imposed pursuant to various agreements it had in place with FAIHS.103 Ness recorded a consolidated loss of

$2.728 million. 104 Without the imposition of these charges it would have recorded a substantial profit. However the continuation of profits was dependent upon the level of sales achieved by HSI.

The failure of HJH Insurance 203

On 3 August 2000 Cooper wrote to Williams seeking further 'short term' funding of $750 000. 105 Williams instructed William Howard to send the money and it was remitted on the same day. 106 On 10 August 2000 Adler wrote to Williams advising him that HSI's situation was 'dire' with 'spiralling sales going down' and seeking further funds. 107 On 16 August 2000 Adler advised Howard that HIH had agreed to loan a further $2.5 million to HSI 'in order to meet urgent financ ial

commitments' . 108 It seems the money was sent shortly afterwards. 109 Again Williams did not seek any indication whether further funds would be required. Nor did he inquire whether HSI was ever likely to be able to repay the funds or whether they were adequately secured. 110

On 24 July 2000 Adler wrote to Williams seeking an indemnity from HIH for acting as a director of HSI. 111 On 3 August 2000 he repeated that request stating, among other things:

To date, I have taken no Director' s fees or any salary or financial disbursements of any shape or form from HSI, I was just there to protect HIH's interests. 112 [emphasis added]

In a postscript to the letter Adler suggested that upon his return from overseas he should become 'caretaker Managing Director' ofHSI.

A form of letter of indemnity was prepared in September 2000. 11 3 It was presented to the meeting of the full board of HIH on 8 September 2000. The minutes record that Adler had been appointed as a director of HSI at HIH's request 'as the company's representative on the board of HSI' .114 The board resolved to grant the indemnity. 115

On 26 August 2000 Cooper sent Adler a facsimile from Hayman Island. 116 The facsimile is generally unintelligible but appears to recite the various dilemmas facing HSI including its considerable debt burden. It proposed a sale by HSI of 50 per cent of Ness to HIH. 117 On 6 September 2000 Adler wrote to Williams 11 8 putting a proposal for HIH to purchase Ness. The letter stated, among other things:

204

I am very concerned about the operations of HSI but in view of our meetings yesterday, I am much more concerned about the value at which HSI is valued in the HIH accounts.

According to the information I saw yesterday, HSI is valued in HIH 's books at approximately $12.4 million which I am told equates to $3.00 net assets per share in HSI, therefore, HIH has already taken a $10 million write-down but on current information before me, as Chairman of HSI, the net asset per share will be negative when HSI reports its results given the question as to whether HSI is a going concern.

This will put at risk not only your current valuation but potentially cause the loans due to HIH ($15 million) to be written off or at least to be heavily provided against. Therefore, before we talk about class action and operational issues for the fiscal year just past and in the future, HIH may have to take a write down of $37 million (initial $10 million plus $12.4 million plus $15 mi llion}.

Home Security International: a case study

There is a series of transactions which I believe would be very beneficial to everyone:

1. HIH purchases NESS for $36.5 million (the original cost of NESS thereby ensuring no write down of that asset);

2. HSI and NESS enter into a five year agreement whereby HSI or its appointed nominees purchases 1,000 systems a month at $495 per system (including GST) in year one with a scale as to volume and price over the next four years. In this way, NESS will have reliable income and then it is up to the management of NESS to make significant profits from the rest of the business and/or through the incremental systems sales from HSI.

3. On receipt of$36.5 million:

a) $15 million is repaid (loans) to HIH;

b) $5 million is placed on deposit with FFC thereby

ensuring FFC' s strength and viability which will be used to pay for existing monitoring obligations;

c) $2 million is to be provided to HSI and set aside by HSI to settle and/or defeat the class action;

d) $3.5 million is used to pay for the AMA 'book' which has a value of approximately $7 million which will help increase the net assets of the company for valuation purposes;

e) The management restructure, contract renegotiations and overhead reduction program will be completed;

f) The balance of the funds will be used by HSI as working capital;

This means that there will be net cash left over from HSI . of $11.0 million (remember, HIH owns 47% of HSI). This will make HSI financially strong, will restore stakeholder confidence, support a net asset per share value of US$3 and will free up executive time to focus on HSI's future growth strategy. With these series of deals facilitated, there will be a strong FFC owned by HIH, a strong NESS which is, in essence, owned by HIH today. It will free HSI of all debt and allow it to relaunch itself. The Chubb deal currently under discussion will only enhance the transactions if it is completed.

Hopefully, within two year period all of the various components including HSI will be trading well. [emphasis added]

In the underlined portions of the letter Adler clearly refers to information he had acquired as a director ofHIH. I will consider the significance of this below.

Williams referred the proposal to Richardson and Howard. Howard liaised with MacDonnell. MacDonnell sent him information concerning the percentage hold back charge beingJev.ied by FFC to HSI11 9, a schedule enclosing a drafLprotit and

The failure ofHJH Insurance 205

loss account for FAIRS 120 and a schedule providing a breakdown of approximately $5 million in management charges levied by FAIRS against Ness.121

On 11 September 2000 Richardson sent an email to Howard and Fodera in which he set out a draft structure of a deal. 122 It was embodied in a letter that Williams sent to Adler on 12 September 2000.

123 Williams's proposal involved a purchase price of

$36 million (it was meant to be $36.5 million) being apportioned so that $18 million was used to repay loans back to HIH, $2 million in cash was left as working capital for HSI and the remainder took the form of a bond issued by HIH in favour of HSI. Williams ' s response did not take issue with the purchase price or the value of Ness. The difference of substance between the two proposals was the amount of the purchase price that was to be used to repay the loans outstanding in favour of HIH ($15 million as opposed to $18 million) and the break up of the remainder.

On the evening of 12 September 2000 there was a meeting or series of meetings and a telephone conversation between Adler, Williams, Howard, Cooper and Richardson. 124

On 13 September 2000 Adler wrote to Williams 125 purporting to record an agreement reached at the meeting for HIH to buy Ness for $36 .5 million with $15 million to be applied to repay the loans outstanding to HIH, $10 million to be provided in cash by HIH to HSI (with $2 million cash to be put aside by HSI to fi ght or settle a class action against FAIRS by disaffected customers) and the remainder to be in the form of a bond issued by HIH to HSI.

On 15 September 2000 Adler wrote to Williams 126 urging the completion of the deal. He stated that unless the Ness transaction was completed, as a director of HIH he could not vote to adopt its accounts if they contained a valuation for HSI shares that reflected the booked value of Ness and otherwise assumed HSI was a going concern. 127

On 15 September 2000 Cooper wrote to Howard 128 urging the completion of the Ness sale. He advised him that HSI's auditors were querying whether the Ness sale would be completed such that they might require a write down of HSI's goodwill which would result in an asset value per share of US$1.50 irrespective of completing the sale of Ness. He also stated that without the sale of Ness to HIH, HSI would report a negative tangible asset backing per share and it would cause write downs in HIH's accounts of$47 million.129

About this time it was realised that if HIH purchased 100 per cent of Ness it would require HIH to bring to account an amount of goodwill represented by the difference in the purchase price and the net tangible assets of Ness. 130 A meeting occurred between Adler, Williams, Richardson and Howard at which the problem with goodwill was discussed. The evidence differed as to whether the goodwill problem was explained to or by Adler. 131 Williams and Adler continued to discuss the means by which the agreement could be kept alive but Richardson said it should not proceed. 13 2 Adler revised the proposal so that HIH would buy 49 per cent of Ness. On 21 September 2000 he wrote to Williams proposing that HIH buy 49 per cent of Ness for $17 million, with $10 million used to repay loans and the balance to be used as working capital. 13 3

206 Home Security International: a case study

There was further correspondence and discussions which resulted in a revised deal summary being signed by both Williams and Adler stating as follows 134 :

HIH/HSI Deal Summary

1. Mr Rodney Adler becomes CEO of HSI.

2. HIH buys 49% ofNess from HSI for $A17.5m. HIH has the first and last right of refusal to acquire the remaining 51% and HIH will consider a drag along clause to address the introduction of a bona fide third party buyer for Ness.

Furthermore, a Shareholders Agreement in relation to Ness would be entered in to [sic] protect the interests of both shareholders and management of all parties in the event of a change in ownership, insolvency and other usual occurrences covered by such agreements.

3. HSI repays HIH loans to the total of $Al3m. HIH will provide HSI with a further $A2.5m of funds by 30 June 2001.

4. The issue of the HSI/Ness manufacturing agreement to be assessed subsequent to review of same by Bill Howard with the management ofHSI and Ness.

5. HIH to meet with Clayton Utz to review class action and to give comfort on meeting their costs associated with that action.

6. HSI to finalise the Retail Support Deed and Master Receivable Agreement with FFC with the essential terms.

a) Funding cap of$Al00m.

b) Interest rate of 15% for 12 months to 30 September

2001 and to be reviewed on the basis of volumes but will be subject to FFC Board approval.

c) FFC to work with HSI in the event of a change in its

business model but must fit the acceptance criteria of the W estpac Securitisation program.

d) FFC to provide finance in Australia, New Zealand and the United Kingdom.

Following the signing of the deal summary on 27 September 2000 Adler wrote to Howard 135 and on 28 September 2000 to Williams 136 seeking payment of the $4.5 million net cash amount owing to HIH. Howard arranged for the monies to be paid to FAIRS on 29 September 2000. 137 At the time the money was paid the only documents recording the transaction were the deal summary signed by Adler and Williams and a draft share transfer form. 138

The formal documents recording the Ness transaction were not executed until 27 December 2000. 139 By that time HIH had entered into an agreement to sell its 47 per cent interest in HSI to Cooper for a purchase price that appeared to be $1.25 million (see below). As contemplated by the deal summary there was a

revised manufacturing agreement. 140 But there was no mechanism by which HIH

The failure of HIHJnsurance 207

could prevent the imposition of fees on Ness pursuant to the various agreements under which the charges referred to above had been levied. Without it, HSI could levy fees at such a level so as to render HIH's 49 per cent worthless.

22.3.2 Whether the sale was at an undervalue

I am satisfied that a review of the history of the negotiations that led to the Ness purchase reveals that the purchase price was driven solely, or at very least substantially, by a desire to maintain the value of Ness in HSI's accounts. The aim was to avoid a write-down in the net tangible assets of HSI and any consequential write-down of the loans and HIH's shareholding in HSI for year end 30 June 2000. The principal matters debated during the negotiation were how much of the purchase price paid by HIH was to be used to repay the loans owing to HIH and how much was to be left with HSI for working capital. Those figures were ultimately determined to be $13 million and $4.5 million respectively.

The Commission received an expert report from Mark Pittorino, a director of Deloitte Corporate Finance Pty Ltd 141 , being an 'indicative' valuation of a 49 per cent shareholding in Ness as at September 2000. Having regard to comparable earnings multiples for companies in the same industry 142, he concluded that an

indicative valuation range for a 49 per cent shareholding in Ness was between $6.370 million and $7.595 million. 143 This was subject to the caveat that abnormal items, namely the management fees charged to Ness by F AIHS, would not recur. 144 Pittorino added that if it were to be assumed that these expenses would recur in future years then his indicative market value of Ness at September 2000 would be significantly reduced. 145 Pittorino does not opine as to an indicative range of values taking into account recurring management fees. Although I have described Pittorino's valuation as 'indicative' both his overall valuation and his caveat concerning management fees are consistent with the offer made by Rokonet in August 1998. I am satisfied that if management fees were not being charged and with appropriate protection for a minority shareholder the fair market value for 49 per cent of Ness at or around September 1998 was between $5 million and $8 million. If the level of fees that had been levied continued to be charged the company appeared incapable of achieving profits. Forty-nine per cent of Ness was certainly not worth the price HIH agreed to.

Pittorino ' s report also contained a brief statement of the inquiries one would reasonably expect a prospective acquirer of Ness would have undertaken in valuing a company including reviewing recent results and the various rebate agreements that were in place etc. 146 Whatever were the appropriate steps to take none of them was taken by HIH. The transaction and the value attributed to Ness was not driven by any desire to acquire a valuable asset for a proper price. It was driven by a need to justify the book value of that asset in the vendor's accounts irrespective of what it

was actually worth.

Even without making, specific inquiries, the information in the possession of HIH or available to it would have indicated that Ness was worth far less than what was

208 Home Security International: a case study

being paid for it and that the deal summary that was entered into did not sufficiently protect HIH. I mention two matters. First, a perusal of Ness ' s accounts 147 would have revealed the level of charges and their effect on Ness' profitability. Second, Cooper' s letter of 15 September 2000 to Howard specified that there would be a write down of HSI's intangibles if the Ness transaction did not proceed. It also stated that a write down in net assets per share would result from a revised assessment of Ness ' s carrying value. It confirmed that the carrying value of Ness was far Jess than its book value.

22.3.3 Ness-summary

Williams and Ness Williams gave evidence 148 that the purpose of the Ness transaction was to place HIH in a stronger financial position in that it gave HIH equity for its investment rather than debt. However the debt was only repaid by using HIH's funds and it was secured over Ness itself (under the Ness facility) and the investment was only worth what Ness's true value was . Williams also asserted that 'the valuation of the asset was left with [William] Howard' 149 and in his oral evidence stated that he had left it to Howard and Richardson to 'look at the valuation ofNess'.

150 I do not accept this

assertion. He could not recall a valuation of Ness and was not advised that any valuation had been performed. 1 1

The one matter that was never debated during

the course of the negotiations was the value to be attributed to Ness.

Further, Adler's letters to Williams of 6 September 2000 152 and 15 September 2000 153 would have placed Williams on notice that, subject to the question of writing down intangibles, if the Ness transaction did not occur then HSI would have to write down the value of Ness because any objective assessment could not justifY the value that it was being maintained at in HSI's accounts. I am satisfied that Williams committed HIH to a purchase of Ness when he either knew the price agreed was well in excess of the true value or was reckless as to that. He did so with the intention of (artificially) justifYing the book values of HIH's shares and loans with HSI.

Adler and Ness Adler was a director of both HIH and HSI. His position was clearly a difficult one. As a director and chairman of HSI, Adler was aware of the terms of the Rokonet offer, that significant management fees were being charged by FAIHS to Ness 154, and that as a consequence the question of control of Ness following its sale was

important to HSI. 15 5 Consistent with what was stated in his letters of 6 September 2000 and 15 September 2000 Adler told the Commission that he was aware that unless HIH purchased Ness on the terms being discussed, he could not sign off on the accounts of HSI with a book value for Ness of $36.5 million. 156 He accepted that the purchase price for Ness was chosen by reference to the book value in HSI's

books. 157 I am satisfied that Adler was well aware that the transaction was a grossly advantageous one for HSI with the only commensurate benefit for HIH being the value it could attribute to its HSI shares.

The failure of HIH Insurance 209

In both his evidence and his submissions Adler disclaimed any responsibility to HIH in relation to the transaction. He contended that it was Richardson's role as HIH's paid adviser to justify that value. 158 Adler pointed out that Williams, Howard and Richardson appeared to understand that Adler was somehow 'representing' HSI in the negotiations and referred to the fact that hi s shareholding in HSI had been disclosed to Williams at least. Thus Adler submitted that 'provided he did not also participate in HIH ' s deliberations ' his conduct was not inappropriate. 159

The difficulty with this is that Adler went beyond merely representing HSI. He sought an indemnity from HIH for acting as a director of HSI. During his dealings with Howard and Williams he continually made reference to his position as a director of HIH and the knowledge he had of problems with its accounts if the transaction did not proceed and the value of HSI could not be sustained. In my view Adler invoked his knowledge and position as a director of HIH in his dealings with Howard and Williams in order to persuade them to accept the transaction. I consider that he did so in the knowledge that HIH was entering into a commercially disadvantageous transaction. He, like Williams, was a person who owed an obligation to protect HIH's interest. In fact he was aware even more than Williams, that the purchase price of Ness could not be justified.

22.4

22.4.1

HIH sells out of HSI-September 2000 to December 2000

Cooper buys the shares

On 6 November 2000 Adler advised Cooper and the HSI board that he was resigning as chairman and chief executive officer so as 'to retain what [was] left of our friendship and [stop] the constant arguments '. 160

After Adler's resignation Cooper wrote to Howard seeking a price for HIH' s shareholding in HSI. 16 1

In late November and early December 2000, Howard and Cooper had further discussions concerning the purchase ofHIH' s shareholding in HSI. Cooper told the Commission that around this time he had a meeting with Williams (described by him as the 'divorce meeting'). It was agreed that HIH and HSI would separate and all of Cooper' s various claims would be settled.162 Cooper said that Williams then passed the matter onto Howard. 163 Williams did not give evidence of any such meeting.

On 5 December 2000 Cooper wrote to Howard referring to recent discussions. 164 Enclosed with Cooper' s facsimile were three documents headed 'Home Security International Term Sheet'. Each of the term sheets proposed various transactions whereby Cooper would purchase HIH's 47 per cent stake in HSI at a specified price but with corresponding financial commitments from HIH. In the first term sheet the purchase price for HIH's stake was $5.3 million but HIH was required to: complete

210 Home Security International: a case study

the Ness commitment (see point 5 of the deal summary referred to above) by paying $2.5 million, repurchase the F AI brand name for $9 million and compensate F AIHS for a reduction in the discount rate applied by FPC by paying $2.7 million. While these were described as 'separate not related transactions' I am satisfied that the contrary was the case. The other two deal sheets suggested variations on these transactions for different sums. Under all three deals the amount to be paid by HIH to Cooper and F AIHS exceeded the amount to be paid by Cooper.

Ultimately there came into existence two term sheets dated 8 December 2000 both signed by Cooper as 'chief executive' of HSI and by Williams as 'chief executive officer' ofHIH. 165 They provided as follows:

Home Security International-Term Sheet:

Brad Cooper has agreed to purchase HIH's 47% stake in HSI as discussed with Bill Howard for a price of A$1.25m.

The terms of repayment are over a two year period being,

Deposit

Year 1

Year2

450k 166

250k

550k

F AI would draw a cheque to Collingwood for $250k in regards to sponsorship. 167

Home Security International-Term Sheet

HSI will relinquish the FAI name on the 1st July 2001 for the forgiveness of the $2.5m debt, and the payment of the class actions cost. If HSI does not secure a deal with Chubb HIH will contribute $350k towards the cost of changing the name.

If the deal with Chubb proceeds HSI will make a further payment of $1m to HIH on the date of completion. 168

Howard gave evidence that there was a meeting between Williams and Cooper on 8 December 2000 at which he was not present. He said that after the meeting Williams gave him the signed term sheets and told him that agreements had been reached with Cooper as to the sale of the HSI shares and the repurchase of the F AI name. 169 Williams denied he met Cooper on that day 170, and said that Howard negotiated the term sheets and presented them to him to sign. He said he relied on Howard's advice that the price was suitable.m I do not consider it is necessary to decide between these two versions of events.

The term sheets for the sale of HIH' s shares in HSI link the purchase price for those shares to the drawing of a cheque to the Collingwood Football Club. A cheque for $250 000 was duly drawn 172 and sent under cover of a letter of 11 December 2000 addressed to Cooper. 173 The letter stated as follows:

The failure ofHJH Insurance 211

I am very pleased to confirm that we were able to finalise the F AI Insurance/Collingwood sponsorship. After reviewing the file, I understand that HIH committed to this sponsorship sometime in May or Jun e this year.

The sponsorship is for two years and the benefits outlined are to be sorted out and finalised sometime in January next year. In regards to the payment of $250,000, HIH will make this payment and pay the 2 years ($250,000) immediately.

We are very sorry for the delay in setting this matter and hope you understand that through some of the internal challenges that we have faced, the delay was very necessary. However, we are pleased to conclude this matter and will forward a cheque to you office by courier today.

Thank you for your [sic] patience and understanding. [emphasis added]

Howard said he signed the letter but that it was drafted by Cooper. 174 Howard told the Commission the claim for a payment of the sponsorship monies to Collingwood Football Club was first raised by Cooper with him either on 8 December 2000 or the day before. 175 He recalled advising Williams that Cooper had requested that the purchase price be raised from $1 million to $1.25 million because Cooper wanted Collingwood to receive a sponsorship for $250 000 and Williams agreed. 176 Howard never saw any documentation suggesting that such an arrangement had been reached at an earlier stage although he recalled Williams being aware of the issue. 177

Williams recalled that the question of the sponsorship of the Collingwood Football Club had been raised in May or June 2000 and he referred it to a division of the company but gave no commitment. 178 Cooper asserted that in March or April 2000 he outlined the benefits of such a sponsorship to Williams who advised him that HIH 'would proceed'. 179 He said that various documents were then sent to HIH but no sponsorship monies were forthcoming. 180 Various documents were provided by Cooper to the Commission concerning this sponsorship proposal. 181 The material reveals that on or about 23 June 2000 Cooper, purporting to act in his capacity as vice president of Collingwood, wrote to Stuart Korchinski of HIH setting out a

'proposal' for sponsorship. 182 Having regard to the other material before me I consider it improbable that Cooper would have sent such a letter in June 2000 if he had received a commitment in the fotm he said he did in May 2000. It follows that, on this issue, I do not accept Cooper's evidence. I am satisfied that prior to December 2000 there was no 'commitment' of any kind to provide sponsorship to Collingwood. There was only an indication that it might be considered. The letter confirming the sponsorship stated that it had been committed to in May or June 2000 although I have found that was not the case. The effect of its inclusion was to inflate the purchase price for the HSI shares. Presumably this made it more palatable to HIH.

212 Home Security International: a case study

Although the term sheets signed between Williams and Cooper referred to an initial payment of $450 000 for the shares, Howard later agreed to vary the initial payment amount to $250 000. 183 The payment of $250 000 was made by Cooper on 12 January 2001.

184

The other term sheet referred to a relinquishment of the use of the brand name 'F AI' by HSI in exchange for the extinguishment afFAIRS's debt of$2.5 million to HIH and payment of the class action costs. Both Howard and Williams told the Commission that they were anxious to terminate Cooper and HSI's ability to invoke the F AI name because F AI' s retail insurance 1 ines were being transferred to the Allianz joint venture and the brand name 'FAI' was considered valuable. 185 On

12 January 2001 a deed was executed between FAIRS and FAI Insurances Ltd whereby FAIRS relinquished the right to use FAI's name. In exchange, FAI Insurances agreed to forgive the remaining $2.5 million debt outstanding since the Ness transaction and pay $1.95 million, being the costs of the class action brought against F AIHS by certain consumers who had purchased a SecurityGuard system. 186 The deed further provided that if by 31 December 2003 a merger with Chubb

Security had not occurred HIH would pay FAIRS $350 000 but if the merger had occurred F AIHS would pay HIH $1 million. 187 Consistent with this, on or about 12 January 2002 the class action costs were paid to FAIHS. 188

22.4.2 Cooper and the $1.12 million transfer

On 13 December 2000, shortly after Cooper had agreed to purchase HIH's share holding in HSI and thereby gained control of HSI (and its subsidiary F AIHS), $1.12 million was transferred from F AIHS' Westpac account189 into the account of one of Cooper's private companies, Speakeasy Pty Limited. 190

When Cooper first gave evidence to the Commission, he could not explain the basis for this payment other than to indicate that he would ask his accountant. 191 A statement was provided by his accountant, Brian Ferguson 192, who sought to explain the basis for the payment. Ferguson stated that the payment was made pursuant to a consultancy agreement between HSI and Speakeasy. It comprised consultancy fees owed by HSI to Speakeasy for providing Cooper's services for the period April to October 2000 plus three months termination pay.

193 Annexed to his statement

were various invoices 194and reconciliations. 195 However it emerged that Ferguson had no direct knowledge of the basis for the payments. He did not create the invoices nor was he aware when they were created. 196

There are further difficulties with Cooper's explanation that he received the monies for unpaid consultancy fees. In June 2000 Cooper wrote to Richardson and advised him that his package was cancelled in March 2000. 197 On 20 October 2000 Cooper and Adler signed a memorandum which resolved Cooper's claims and provided that HSI and FAIRS would not pay Cooper for outstanding consultancy fees.

198 (Cooper

said he signed this under duress. 199 I do not think this is plausible.) Both of these matters are inconsistent with any entitlement on the part of Cooper to receive payment in December 2000 for outstanding consultancy fees.

The failure of HIH Insurance 213

Counsel asststmg submitted that there was no proper basis upon which Cooper could procure or receive the payment of $1.12 million from FAIRS to Speakeasy in December 2000. In his submissions Cooper denied this. He pointed to the evidence of Ferguson, who reviewed the documentation in January 2001. Cooper asserted that he was told by MacDonnell ofF AIRS that the monies had been paid pursuant to a 'memorandum of understanding' to which Cooper was a party. Cooper otherwise submitted that the Commission had not called MacDonnell and for that reason should not proceed to make any adverse finding against Cooper. I do not think that is right. I have already dealt with Ferguson's evidence concerning the invoices. And although Ferguson did refer to payment being made under a memorandum of understanding, the memorandum annexed to his statement said nothing about the payment of this sum. All that Ferguson said about MacDonnell was that MacDonnell had informed him that the money had been transferred. So much was not in dispute. The material to which I have referred reveals that, to the extent there had been discussions over Cooper's 'deferred consultancy fees', by 20 October 2000 Cooper had agreed to forgo those amounts and settle various claims he had with HSI and FAIRS. Without board approval (at least) he was not entitled to procure the transfer of those funds or retain them. The board minutes of HSI do not contain any authorisation for this type ofpayment.200 MacDonnell could not cast any light on that because he did not speak for the board.

22.5 Cooper's claims-December 2000 to March 2001

Between December 2000 and March 2001 Cooper pursued various 'claims' upon HIH either on his own behalf, or on behalf of his private companies or on behalf of FAIHS. By that time he controlled FAIRS though his purchase of HIH's stake in HSI. I will deal with each claim separately although they overlap and most have their origins in events prior to December 2000.

I have commented in Chapter 17 on the cash flow difficulties that HIH faced in this period. For reasons that were never satisfactorily explained, HIH's cash flow problems seemed to present little impediment to Cooper receiving funds in the period December 2000 to March 2001. Funds were disbursed to him promptly, often on the day of or shortly after the relevant 'settlement' had been reached.

22.5.1 Remaining Ness monies ($2.5 million)

Clause 3 of the HIH/HSI deal summary for the sale of Ness201 provided that HIH would provide HSI with a further $2.5 million by 30 June 2001. 202 No corresponding obligation was provided for in the final contractual documentation. Clause 13 of the Shareholders Agreement provided that FAI Insurances was to provide $1.5 million in further funding to Ness on or before 28 February 2001. 203 On 21 December 2000 Howard advised HIH's solicitors that the $1.5 million commitment replaced the obligation in the deal summary. 204 Nevertheless, on or · about 5 January 2001, $2.5 million was paid over to FAIHS. 205 Even though

214 Home Security International: a case study

Howard had initiated the paymene06 he could not explain why it was being sent on 5 January 2001 when HIH's cash flow was tight and in circumstances where the term sheet only required that it be sent by 30 June 2001. 207 No plausible explanation was provided as to why $2.5 million was paid and why it was paid at such a difficult time for HIH.

22.5.2 Compensation for change in FFC discount rate ($2.65 million)

Point 6(b) of the signed deal summary for the Ness sale provided that FAIRS would obtain a favourable rate of discount on the terms upon which FFC would provide funds to its customers.208 For various reasons this commitment could not be implemented and Cooper sought compensation. On 21 December 2000 Howard advised Jeff Jurd of FFC that it had been agreed that HIH would pay $2.65 million to FAIRS to settle the issue and the settlement had been approved by Williams.209 The monies were paid to FAIRS on 22 December 2000. 210 I make no criticism of Howard on this issue. He appears to have been putting into effect a commitment made by Williams.

22.5.3 Sponsorship of Vision Publishing and the Goodwill Group

It will be recalled that on 21 March 2000 Richardson wrote to Cooper advising him that, 'as a separate matter', HIH had agreed to sponsor the forthcoming seminars to be produced by Vision Publishing for an amount of $1.2 million. 211 Throughout 2000 Cooper sought payment of those monies. 212

By November 2000 the monies had not been paid and the seminars had not been held. On 21 November 2000 Cooper wrote to Howard on Vision Publishing letterhead. 213 He referred to the fact that HIH had agreed to sponsor Vision Publishing for $1.2 million. He also noted that another of his companies, the Goodwill Group (formerly Cervale Pty Ltd), owed FFC various amounts under the factoring arrangements described above. He proposed offsetting one against the other with the result that a balance of $34 7 500 would be paid to Vision Publishing. He enclosed an invoice for that amount. 214

Cooper's proposal was accepted such that the $1.2 million Vision Publishing 'sponsorship commitment' was satisfied by a payment of $347 500 and the offsetting of the two debts owed by Goodwill to FFC. A letter dated 15 December 2000 from Jurd of FFC to Cooper confirmed receipt of the monies owed by Goodwill. 215 Howard told the Commission that this proposal was agreed to by Williams sometime in late November or early December 2000. 216 Williams denied any knowledge of this 'settlement' .217 I prefer Williams's account. Despite the fact that the debts were being offset in respect of different companies, Howard did not obtain any deed or agreement recording the proposal.

Williams told the Commission that on 23 December 2000 he was telephoned by Cooper who asked to meet him. Williams agreed. Cooper raised the outstanding

The failure of HIH Insurance 215

sponsorship for Vision Publishing. Williams advised Cooper that it was being referred to Howard. 218 Cooper did not tell Williams about the set-off.

Cooper sent to Williams a facsimile dated 28 November 2000. 219 It stated, among other things:

I have worked for the last 8 weeks to achieve our agreed objective. This is the update that I'm very pleased to provide to you.

I. I had 2 loans to FFC total ling $ 1.5million. I have repaid over the last 18 months $3 5 000 per month plus interest to FFC. The attached letter confirms that I have now settled the outstanding $850 000 plus interest and honoured my commitment and settled my loans in full. (See attached letter).

2. I have purchased HIH's 47% shareholding in HSI. This agreement has been signed and we are now making certain that all legal USA regulatory requirements are being met in relation to such a significant purchase ...

7. Ray, as I have completed all of the above, and paid my loans on a monthly basis I have one thing left to request, that the attached letter (which you have seen before on your file) which confirm that HIH had guaranteed to sponsor my Company Vision for $1.2million.

Ray it is absolutely critical that this amount be settled as it was a commitment and I am relying on these funds to help make up the $5million that we will need between now and the end of March. Please note that at no time did I stop my repayments to FFC 6f-tfy to offset these loans against the $1.2million.

Would you please sign below confirming your acceptance of Point 7, which approves the immediate payment and allows us to go to Christmas and take a well earned break knowing we are coming back to a health company with significant upside. [emphasis added; strike-through in original]

Although this letter is dated 28 November 2000 the transmissiOn annotations indicate it was sent on 20 December 2000. I am satisfied it was sent then. The Commission does not have the letters that were said to be enclosed. However, I infer that the 'attached letter' referred to in paragraph numbered 1 above was Jurd's letter of 15 December 2000 and the 'attached letter' referred to in the paragraph numbered 7 is the letter from Richardson of21 March 2000 confirming the sponsorship. I also infer that the reference to an agreement that had been signed for the sale of HIH's shareholding was to the term sheet signed by Williams and Cooper on 8 December 2000.

216 Home Security International: a case study

On 3 January 2001 Howard sent a memo to Williams.Z 20 It was headed 'Vision Publishing $1.2m'.lt relevantly stated as follows:

Dear Ray

I have been asked by Brad Cooper (many times) for the finalisation of this issue as part of the agreement to finalise all matters between HIH and HSI, and other entities.

Brad has forwarded to myself the following document in regards to this issue and the last paragraph appears to be quite self explanatory. I understand that Brad has discussed this issue with you . All other points have been completed in the last 4 weeks, the major being:-• The NESS acquisition and shareholders agreement

• The F AI name repurchase

• The Master receivables purchase agreement

• The retail support deed

• The payment by Mr Cooper of his commitments to Finance corporation

• The HSI sale

• The class action agreement

As an attempt to now finalise the last few issues (this being the main one) it would appear prudent to settle this as soon as possible so that we can move forward on HIH's own matters concerning the future. Through buying the HSI stake Brad is clearly in the need for cash to support the operation going forward, and this no doubt will help him in the process. The memo from us is quite straight forward, and while we may like to argue the toss, it appears binding, and is one that we would probably lose.

Another step in the extraction of the HIH group from the HSI web.

Brad said that he would like to finalise this ASAP and will no doubt be in contact today. [emphasis added]

The memo tendered to the Commission does not have the 'following document' referred to in it. But it seems likely that it was the letter Cooper faxed on 20 December 2000. I am satisfied that in this memo Howard wrongly advised Williams to the effect that Cooper's FFC debts had been repaid but that the Vision Publishing Sponsorship commitment was still outstanding.

Williams told the Commission that in response to this memo he wrote a note to Howard. 221 He advised him of the background to the Vision Publishing sponsorship in March 2000 and that Cooper had raised it again on 'Christmas eve' (although this should be a reference to 23 December 2000). His note also stated:

Clearly we cannot pay over a sponsorship fee be it $1.2m (or less) without the full details of what is now proposed and, most importantly, when the event will be staged.Z 22

The failure ofHIH Insurance 217

There was a meeting between at least Howard and Cooper on Friday 5 January 2001. On 8 January 2001 Howard prepared a file note as follows:

This file note it to confirm that on the previous Friday that Ray Williams agreed to pay $750 000 to a company associated with Brad Cooper in settlement of a commitment made by RRW and Colin Richardson.

The author is waiting for confirmation from RRW (by fax) of the verbal agreement reached on Friday 5 January 2001. By way of note to the issue, RR W made comment that "he would have settled for $650 000 should he have handled the matter". I said that was good but I had to deal with BC for 40 minutes? 23

On the same day Cooper forwarded an invoice from the Goodwill Group for $825 000 (that is $750 000 plus GST) which is dated 27 December 2000. 224 The invoice refers to the 'balance of Sponsorship package and Consultancy Fees for the years 2000 and 2001 '.

Howard's evidence was that his note recorded a meeting attended by himself, Cooper and Williams where Williams negotiated the settlement amount. 225 Williams denied attending or giving any instruction to settle the matter. He said that after the meeting between Cooper and Howard, Howard phoned him and told him that he had negotiated a deal $750 000 for the sponsorship and Williams had responded that he thought he could have settled it for $650 000.226 I accept Williams's version. The terms of the notes that passed between himself and Howard are consistent with his evidence. Howard's note recording Williams' s dissatisfaction with the amount agreed to be paid to Cooper sits oddly with an assertion that Williams himself negotiated the payment amount at a meeting with Cooper. More importantly Howard' s evidence has to be considered in light of the fact that he settled the payment of the Vision Publishing sponsorship in early December and then told Williams in early January that it was still outstanding.

Howard said that even though the agreed amount was $750 000 he thought that it was exclusive of GST and the appropriate amount was $825 000. 227 He recalled that the terms were that half was payable immediately and the remainder within four months. By 12 January 2001 Cooper had received $412 500.228 Howard

inquired whether Cooper was interested in rece1vmg a discounted payment immediately. 229 On or about 15 January 2001 Howard and Cooper agreed upon $325 000 which was paid that day.230

22.5.4 Summary-Goodwill sponsorship

Cooper Cooper was paid his sponsorship twice without ever having provided any seminars. He did so by first reaching an agreement whereby he was to receive $375 000 and the balance was to be set-off against monies owed by Goodwill to FFC. Then, when armed with a letter from FFC stating that he had paid out his obligations to them, he

218 Home Security International: a case study

wrote direct to Williams and misled him in order to obtain payment of the full $ 1.2 million sponsorship.

In his evidence Cooper as serted that he had reached an agreement with Williams in their so-called ' divorce meeting' for him to be paid some form of ' sponsorship or consultancy fee' being 'three months salary ... [as] the remaining balance of my agreement' .Z

3 1 He appeared to suggest that the form of the invoice bearing the date 27 December 2000 was HIH' s idea. 232 This explanation is difficult to understand. It is true that the invoice refers to 'sponsorship and consultancy fees' but it was only sent after the further payment had been agreed with Howard on 5 January 2001. It mi ght have been the case that on that day there was some discussion about an invoice being prepared in that form. What is not explained is the letter Cooper sent after his sponsorship had been set-off against his FPC debts and before the 5 January 2001 meeting asserting that his sponsorship was still owing (despite no seminars ever having been provided) and why he stated that to Williams on 23 December 2000. Cooper had no obvious entitlement to unpaid salary from HIH. It never employed him and by the time this payment was made it had sold its shareholding in HSI. Cooper's explanation for the transfer of $1.12 million from F AIHS on 13 December 2000 was that it was for unpaid salary and three months notice as well. I do not find his explanation on this issue convincing.

Howard

Howard's conduct is difficult to comprehend. Counsel ass1stmg submitted that Howard mi sled Williams and paid out HIH' s money when he knew there was no basis for doing so . Howard submitted that he was confused about the basis for the payments and otherwise complains that the memo of 3 January 2001 upon which this submission rests was not put to him when he was called to give evidence. On this latter point I note that after counsel assisting and Howard lodged their written submissions there was correspondence with Howard' s legal representatives inviting them to place before the Commission any material on this topic. This invitation extended to any further written statement from Howard. In those circumstances I am satisfied that it would not be unfair to make a finding on this point. The absence of evidence from Howard in relation to that memo is still a matter I must weigh up. Upon reviewing the material I cannot accept that Howard's statement to Williams in that memo was an oversight. Howard had been intimately involved in the dealings with Jurd and Cooper concerning the sponsorship throughout December 2000. Just two days after the memo he 'settled' the same claim with Cooper and agreed to pay him further money. I am satisfied that Howard misled Williams.

22.5.5 The 'Kirby' claim ($560 000)

On 18 December 2000, Cooper wrote to Howard233 seeking reimbursement from HIH for various expenses and liabilities HIH allegedly incurred during the last five months of 1999 and throughout 2000 in pursuing a joint venture with International Acceptance Corporation (lAC). The joint venture involved the creation of a consumer finance company to fund a proposed expansion of the home security

The failure of HIH Insurance 219

business in Australia, New Zealand and the United Kingdom via the introduction of the 'Kirby order flow'. 234 The proposal was abandoned during the course of the negotiations to sell HSI' s 50 per cent shareholding in FFC between December 1999 and March 2000. Cooper asserted that Richardson agreed that HIH would pay any

out-of-pocket expenses incurred by HSI. 235 He claimed an amount of $780 000 including $575 000 for IAC. 236

Howard said he spoke to Williams about the claim and that Williams confirmed that a commitment had been made but 'Colin [Richardson] had the details' .237 Williams denied having any involvement with the settlement of the claim. 238 Howard said he also spoke to Richardson who confirmed that an oral commitment had been given in order for the FFC purchase to proceed. 239 Richardson denied giving any such commitment. He stated that he told Howard jn December 2000 that the claim was

'spurious' and should not be paid. 240 It is correct that Cooper raised the 'Kirby proposal' with HIH in late 1999. However there is no document supporting his claim that any commitment was made to him to reimburse expenses for it not proceeding.

On 18 January 2001 Cooper wrote to the new chief executive officer of HIH, Randolph Wein. 241 He raised three claims with Wein being the Data Advantage claim (see below), the claim for reimbursement of legal expenses (see below) and the Kirby claim. On 22 January 2001 Wein wrote back to Cooper advising him that he was travelling overseas and that the matter had been referred to Howard. 242 Howard said that he spoke to Wein in relation to the claims and Wein told him to

settle them for approximately half their value. 243 On 7 February 2001 Howard sent an email to Wein confirming that he was:

... authorised to clean up what I hope is [sic] the last remaining matters that HSI has written to HIH about. That is to settle the matters of the Data advantage shareholding, the legal costs associated with HSI/F AI Finance/Ness restructure, and the Kirby costs associated with that same restructure. I will attempt to settle for approximately 50-60% of the claims raised so that we can get on with the aim of exiting from the F AI finance

operation. 244

On 8 February 2001 Cooper wrote to Howard245 asserting that they had resolved the Kirby claim for $560 000 being 75 per cent of the original claim. It seems that that amount was paid on 9 February 2001. 246

Howard understood that an aspect of the claim was for reimbursement of expenses claimed by IAC. 247 Despite this, he did not seek to obtain documentation demonstrating that IAC had been paid. Nor could he nominate what portion of the settlement amount was to be paid to IAC and what portion was to be retained by

HSI. Further, he did not request that any deed or agreement be drawn up to record the terms of the settlement. 248

In his submissions Howard pointed to the correspondence with Wein as evidence that he was authorised to settle these claims and that he kept his superiors informed of what he was doing. That may be so but it does not explain what occurred. By this

220 Home Security International: a case study

time Howard occupied a very senior position within HIH. It was obvious that Wein left matters largely to Howard's judgment as to whether the claims were appropriate for settlement or not and if so at what amount. Nothing in the exchanges between Howard and his superiors amounted to a direction or mandate to Howard to pay Cooper irrespective of the value or merits of his claim. Yet in essence that is what he appears to have done.

22.5.6 Relocation expenses ($275 000 paid)

On 3 January 2001 Cooper wrote to Howard seeking payment of an amount of $250 000 as compensation for various expenses incurred in refurbishing parts of FAl's former offices at 77 Pacific Highway, North Sydney.249 He claimed that he had previously relocated to the 15th level of the building and executed a five year lease 'in my personal company' [sic] and spent more than $250 000 on refurbishing the top floor. HIH had sold the building and he had been issued with a notice to vacate.

On the same day, Adler sent a facsimile to Howard 250 referring to Cooper's

facsimile to Howard and confirming that Cooper had taken up a lease on the 15th floor of 77 Pacific Highway 'at my personal request' and that he had spent a considerable sum of money refurbishing the floor 'believing the lease was there to provide a ten year term'. Howard said he spoke to Adler around this time. Adler confirmed the contents of his letter and added 'I will leave it up to you'. 251

Howard offered Cooper $248 000252 to settle the claim. On 15 January 2001 Cooper wrote to Howard rejecting the offer253 , outlining a further $70 000 in relocation expenses he claimed he would now incur as a result of having to leave the premises. Cooper stated that he would accept $284 000.254 His letter also stated:

Your offer is much appreciated but unacceptable. This obscure clause in my lease invoked to force me out was never explained by F AI Insurance who are charging us full rental despite us helping to fully tenant their building.

255 [ emphasis added]

Cooper's assertion that rent was being charged was not accurate. His companies had not paid rent on the premises for 18 months. 256

Howard wrote a cheque requisition for $275 000 for one of Cooper's companies, Speakeasy Pty Limited, in settlement of the claim. 257 He did not seek legal advice concerning the claim. 258 When asked the basis for settlement he stated that it was a 'normal tenant/landlord thing'. He also referred to the fact that HIH was 'still in a joint venture with' Cooper or HSI and that he had sought the opinion of 'a director

of HIH' (presumably Wein). By this time Cooper had already purchased HIH's shareholding in HSI so the only 'joint venture' the parties were engaged in was FFC's funding of HSI's customers. All that Howard had been advised of was that pursuant to a renovation clause in a lease Cooper was obliged to vacate. 259 He took

no steps to inquire whether there was any legal obligation to pay compensation under the lease or otherwise. He became aware during this period that Cooper had

The failure of HIH Insurance 221

not been paying rent at the premises for a period oftime.260 He told the Commission it did not occur to him to argue against the claim for relocation expenses by referring to the fact that rent had not been paid. 261 Howard had no mandate from W ein to settle doubtful claims on uncommercial terms.

22.5.7 Legal expenses claim ($92 000)

In Cooper's letter to Wein dated 18 January 2001 262 , he said:

As HIH initiated the five (5) contracts that were required to complete the transaction they sought to action, we had made it clear that our cash position was in no way fund these unbudgeted items initiated by HIH [sic] . We have therefore requested that $90,000 be reimbursed for our legal costs, however Mr Howard will not approve this payment which we feel is not reasonable in view of his intimate knowledge of the above .263 [emphasis added]

The contracts referred to were those concerning the documentation of the Ness acquisition, the purchase by Cooper of HIH's HSI shares and the contract concerning the separation of HSI and HIH?64 A review of the history of those transactions reveals that the agreements were initiated by Cooper and HSI not HIH. On or about 16 February 2001 Howard authorised the payment of $92 000 to FAIHS in settlement of this claim.265 It was paid on that day. Howard could not nominate any legal basis upon which it could be said that there was an obligation to pay that amount. However, Howard considered that the settlement was within the mandate given to him to by Wein to 'get rid of the claims made by Cooper'.266 Again, there is little support in Wein's mandate to Howard for the payment.

22.5.8 Data Advantage-submitting the claim to Howard

The other claim raised by Cooper in his letter to We in of 18 January 2001 26 7 concerned shares in a company called Data Advantage Limited (Data Advantage). The origins of the claim need to be examined.

On 28 September 1998 Data Advantage listed on the Australian Stock Exchange. It was the parent company of Credit Reference Australia Limited and shares were allocated to members who were consumer finance companies and other users of the credit reference service. 268 On 22 December 1998 Jurd wrote to Adler pointing out that the shares in Data Advantage had been allocated to F AI Insurances whereas a significant number of the credit references had been undertaken by FFC?69 He sought that it be corrected. At that time FFC was 50 per cent owned by F AI and 50 per cent by HSI.

A facsimile bearing the date 21 June 1999 from Cooper to Adler was tendered to the Commission.270 It referred to Jurd's letter to Adler and stated the shares 'need to be returned'. He requested that they be returned to FFC. The memo has transmission annotations indicating that it was faxed from Adler (Pacific Capital Partners) back to Cooper on 2 August 1999. It bears an annotation in Adler's handwriting

222 H ome Security International: a case study

responding to an assertion that the current market value of the shares was $826 804: 'Today is not relevant as all the above were sold on listing'.

Also tendered to the Commission was a facsimile from Cooper to Adler dated 6 August 1999. 271 It bore facsimile annotations indicating that it was faxed on that day. 272 Cooper advised Adler:

Data Advantage must be resolved before our company is placed in the embarrassing position of needing to serve a formal notice. The shares that were sold did not belong to F AI Insurance; they belonged to FFC and HSI and must be returned to our mutual companies.

Adler wrote on the note 'Dear John & Ronnie. This needs to be dealt with'. Adler told the Commission this was a reference to John Ballhausen, HIH's investment manager, and Ronnie Chalmers. 273 He forwarded the note to Ballhausen.

On 9 August 1999 Ballhausen wrote to Adler advising that the matter of Data Advantage was in Williams's hands. 274 From transmission annotations on that document it appears that Adler faxed it to Cooper with a handwritten notation 'In your hands. Best I can do at this time'. 275 Consistent with this correspondence, Adler told the Commission that in August 1999 he was approached by Cooper to assist with the issue, he passed the matter on to Ballhausen, Ballhausen told him it had been passed on to Williams and he advised Cooper accordingly.276

On 15 January 2001 Cooper wrote to Howard in relation to Data Advantage. 277 His facsimile enclosed a copy of a letter addressed to Dominic Fodera dated 15 January 2001 278 together with copies of several items of correspondence from 1998 and 1999 concerning the claim. 279 Cooper outlined his claim as follows:

... you now need to be aware that FFC was incorporated and 100% owned by HSI from 1992 until early 1997. The allocation of Data Advantage shares to F AI was based on a calculation by the Data Advantage Company.

A copy of that letter and graph clearly confirms that the 217,000 shares were issued to FFC in 1998 because of the business generated by FFC from 1992 until 1998.

My legal opinion confirms that as HSI were 100% owners of FFC that [sic] this must be now calculated on a pro rata basis.

Subsequently, 85% of the shares are the property of HSI as we owned the company for 85% of the period that the benefit was gained. 28 0

In 1998 and 1999 it appeared to have been common ground that the shares should have been allocated to FFC. But Cooper now claimed a direct entitlement on behalf of HSI. In the meantime HSI had sold its remaining shareholding in FFC. The negotiations over the purchase price had taken into account FFC's claim for shares

in Data Advantage?8 1 The claim was entirely without merit.

One of the documents enclosed with Cooper's facsimile was a copy of Cooper's memo to Adler dated 21 June 1999282 to which I have just referred. However this

Th e failure of HIH Insurance 223

copy of the memo did not have the handwritten annotation noted above. Instead it had the following handwritten annotation:

Phoned RA . He agreed 100% and confirmed pro rata position i.e. HSI owns 85% of Data A shares he would action if not successful.

Cooper was not prepared to identify the note as being in his handwriting. 283 Adler denied making any such agreement with Cooper in August 1999 or at any time. 284 Cooper could not explain why there was a handwritten annotation on this memo in June 1999 purporting to record an agreement for the transfer of 85 per cent of the shares to HSI when the correspondence around the time confirmed that it was understood that any such shares belonged to FFC?85 Cooper denied that he placed that note on the document in January 2001. 286

Cooper's facsimile to Howard of 15 January 2001 also enclosed a copy of Cooper's memo to Adler of 2 August 1999 which had written on it the following handwritten annotation:

Phoned RA. He agreed 100% had issued instructions not to delay and had asked FAI internal to return to HSI very angry not done. 287

This note appeared to be in the same handwriting as that added to the memo of 21 June 1999.

Counsel assisting submitted that Cooper falsely annotated these documents retrospectively to construct an alleged agreement with Adler for F AIHS to obtain the shares. I agree that the handwritten annotations referred to above are suspicious but I am not persuaded that Cooper forged them.

On 30 January 2001 Cooper sent a facsimile to Howard. 288 He sought immediate return of the shares or full financial compensation otherwise he threatened to commence legal proceedings. He also stated:

The attached letter retrieved from archives as discussed last night, completes your file. I have written to you on approximately seven (7) occasions. The file and all correspondence clearly confirms HIH have an asset in Data Advantage shares of which 80% belongs to HSI. Mr Wein had asked you to resolve this issue. [emphasis added]

The document referred to as 'the attached letter' has caused me great concern. It bears the date 2 August 1999, was on 'FAI Insurance' letterhead, had the words 'Rodney S Adler Chief Executive' in the top right hand comer and was signed by Adler. 289 The letter was addressed to Cooper and headed 'Re Data Advantage'. It states:

224

Understanding that this is a material issue to HSI, I am pleased to once again reconfirm that F AI Insurance should have allocated a large percentage of the value of the Data Advantage shares that were issued to F AI, not redistributed back to FFC as per the activity report from Data Advantage which clearly confirms that these shares were the property of FFC and based on pro rata activity, HSI should have immediately received

Home Security International: a case study

the value of this asset. This is an internal matter but obviously self explanatory when one looks at the file.

There are several things to note about the letter. Adler was not the chief executive of F AI as at August 1999 and had no authority to sign any such letter then or at any subsequent time. The letter purported to be written from offices in Kent Street which Adler had vacated many months before August 1999. The letter blurs the significant question as to whether the entitlement to the shares was FFC's or HSI's. In 1999 that distinction was not unimportant but by early 2001 it was critical because by then HSI had no ownership interest in FFC at all. The tone of the letter is

inconsistent with the approach that the other documents demonstrate that Adler took during July and August 1999. They suggested that he merely noted the claim by FFC and passed the matter onto Ballhausen.

Counsel assisting submitted that these matters suggest the letter was prepared in early 2001 and backdated to August 1999. Other copies of this letter290 had transmission annotations indicating that it passed between Adler Corporation and Cooper on 29 January 2001 and then was faxed from FAIRS to HIH on 30 January 2001. I am satisfied that the letter was prepared in January 2001. While I am not certain who prepared its first draft I am satisfied that Cooper knew it had been backdated when he submitted it to Howard and enhanced the impression it created as to its origin by asserting that it had been 'retrieved from archives'.

Counsel assisting further submitted that Adler signed the letter in January 2001 with the knowledge that it was backdated and that it was being used to bolster Cooper's claim that HSI had a direct entitlement to Data Advantage shares. I accept this submission. Adler told the Commission that he assumed he signed it on 2 August

1999 but 'can't be sure' and conceded that it was 'possible' that he signed it at a later date.291 Insofar as the letter suggested that the entitlement to the shares was HSI's, he accepted the letter was not 'particularly well drafted' and restated his understanding that it was FFC that was the rightful owner of the shares.Z92 I have already found that the letter was created in early 2001. I find it difficult to accept

that, due to an oversight, Adler would sign such a letter in January 2001 which was dated 2 August 1999, which referred to him as chief executive of F AI and which sought to bolster a claim by HSI for shares in Data Advantage.

22.5.9 Data Advantage-paying out the claim

On 7 February 2001 Cooper provided Howard with advice from his solicitors, Brown & Co, purporting to support HSI/FAIHS's entitlement to shares in Data Advantage?93 The advice recited that an agreement had been reached on 2 August 1999 between Adler and Cooper that 85 per cent of the gross value of the shares would be paid by F AI Insurances to F AIHS. Cooper could not recall giving any

instructions concerning such an agreement 294 but presumed it resulted from the

documents he provided to Brown & Co (that is, the letter referred to above). 295 The

advice referred to 'an independent third party assessment of the value of FFC' being

The failure of HIH Insurance 225

undertaken at the time of the FFC sale and recited an instruction that the valuer was not told of the Data Advantage claim.

I mean no disrespect to the author but the advice did not reflect the true position. No 'independent third party assessment of the value of FFC' was ever undertaken. It would not matter if the opportunity to take advantage of the Data Advantage shares was or was not taken up in assessing the purchase price. Anyone who was familiar with the negotiations, as Cooper undoubtedly was, would have understood that the negotiations concerning the purchase price did take into account the Data Advantage shareholding. On 17 March 2000 Cooper wrote to Fodera suggesting a purchase price of $14 million. 296 Cooper outlined a number of reasons which

supported that value including FFC's entitlement to the Data Advantage shares. 297

On 7 February 2001 Howard received legal advice from Watson Mangioni concerning the claim. 298 Their preliminary advice was that the material shown to them did not substantiate the claim and that it was a matter for the F AI Group to determine which company was allocated the shares.

Despite the advice from Watson Mangioni, HIH paid FAIHS $1 million to settle the Data Advantage claim.299 How this came about was the subject of some debate.

Howard's evidence was that after receiving the Watson Mangioni advice he referred the file concerning the Data Advantage claim to Jock MacAdie who was then a consultant to HIH and acting as de facto chief financial officer. 300 Howard arranged a meeting between himself, Cooper and MacAdie.301 MacAdie recalled that the meeting occurred on about 12 February 2001.302 MacAdie recalled that during the meeting Cooper raised the Data Advantage claim with him but he said that he would have to discuss it with Howard. 303

It is at this point that Howard and MacAdie's recollections differ. MacAdie claimed that sometime around 14 February 2001 he was approached by Howard who told him he was proposing to pay Cooper $1 million to settle the Data Advantage claim. According to MacAdie, he and Howard discussed the claim and its background and MacAdie asked him whether 'the arrangements and the proposed payments had been agreed to and signed off by all the relevant and necessary people in HIH'. MacAdie said Howard advised him that it had been. 304 Howard claimed that on

14 February 2001 he travelled to the United States and when he arrived at his hotel waiting for him were facsimiles from Cooper (see below). He telephoned MacAdie who told him that he, MacAdie, had settled the Data Advantage claim for $1 million.

305 Cooper told the Commission that he recalled Howard handing the matter over to MacAdie and he reached the settlement with MacAdie. 306

On the day of his departure to the United States Howard met Cooper. Later they were joined by Benedict Tilley to discuss the proposal to sell off the entire HIH property portfolio (see below). 307 Howard could not recall whether Cooper raised the Data Advantage claim prior to his departure. 308 I agree that given the efforts Cooper had gone to pursue this claim it is probable he did raise the claim. And in

226 Home Security International: a case study

view of what transpired they agreed on the $1 million figure. Amongst the faxes waiting for Howard in the United States were ones which stated as follows:

and:

Dear Mr Howard

I am finally pleased to confirm that following my discussion at 11.30am today with Jock MacAdie, he has agreed that you are completely approved and are able to settle the Data Advantage file immediately.

We would prefer the return of the shares. There is a significant upside in this market sector and the value of approximately $1.2million is a material asset to HSI. However, I accept your cash offer of $I million and this letter is to confirm that you will transfer the $1 million between now and of this week into the Westpac account of FAI Home Security .. . 3 9 [emphasis added]

Dear Jock,

Thank you. The long delay in regard to Data Advantage is finally finished.

I have spoken to Bill Howard and informed him that he can now settle the matter. This will allow us a much better position as we seek to resolve the remaining $70million worth of assets and joint ventures between our two groups.

Whilst we may not agree on the exact amount or details, your good faith in settling this matter is greatly appreciated after such enormous delays and frustration in dealing with past management. 310 [emphasis added]

While being far from clear the letters suggest to me that the $1 million settlement was arranged by Howard before he left, with MacAdie being informed that it had occurred.

Howard told the Commission that upon receipt of Cooper's facsimiles he rang MacAdie to confirm that the claim had been settled. He did not query why it had been settled for that amount. 311 Howard telephoned Paul Abela from the United States to authorise the payment. 312 If Howard had passed the matter on to MacAdie and not settled the matter as he claimed, it is difficult to understand why he would telephone Abela from the United States to authorise the cash payment. 313 MacAdie had ample authority to do that. My review of the documents and the undisputed aspects of the evidence lead me to conclude that it was Howard who settled the claim with Cooper.

Cooper obtained $1 million for a claim which was dubious. It was supported by a document of doubtful provenance and flawed legal advice. Howard approved the payment. He knew the claim was doubtful. He had legal advice to that effect. I am satisfied that he did not have an adequate basis to act as he did. I repeat that his mandate from Wein did not provide any justification for his conduct.

Th e failure ofH!H Insurance 227

22.5.10 Publicard ($944 000 debt not pursued; $148 000 refund)

Events pre January 2001 At sometime, possibly in early 1999, Adler entered into an arrangement on behalf of FAI Insurance with Cooper to invest in shares in 'BEA Systems' on the basis that both parties would share in any profits or losses. 3 14 It resulted in a profit and Cooper received a cheque for approximately $166 000 on 8 March 1999. 315 Adler also gave evidence that he entered into a further arrangement with Cooper in or about April

1999 in relation to the purchase of shares in 'Publicard '. Under this 'joint venture' F AI and Cooper would share in profits and losses on a 65 per cent/35 per cent basis, F AI would fund the purchase of the shares and Cooper would pay a I 0 per cent interest rate for not having to put up the funds. 3 16 The agreement was not recorded in writing. Between 15 April and 10 May 1999 FAI purchased approximately $2.7 million worth ofPublicard shares. 317 Cooper and Adler disagreed over whether Cooper was fully appraised of the terms of the joint venture.

Sometime in 1999 the carriage of this investment was handed to Ballhausen, HIH' s investment manager. 318 He noted that the Publicard shares were trading at a loss. On 23 June 1999 he wrote to Fodera and Terence Cassidy advising them that the lo ss was US$573 000. 319 On 13 July 1999 he advised Fodera, Cassidy and Williams that the unrealised losses now exceeded A$1 .6 million. He sought advice as to whether the investments should be realised to stem the losses. 320 His memo noted that he had been advised by Williams that Adler had personally guaranteed Cooper's joint­ venture responsibilities. Ballhausen did not receive any response. 32 1

By March 2000 the share price of Publicard had recovered. Ballhausen contacted Adler who referred him to Cooper. 322 Adler claims that during this conversation he told Ballhausen that, as the share price had now recovered, his guarantee of Cooper was extinguished. 323 Ballhausen denied this was said. 324 I do not consider it

necessary to resolve this dispute. On 1 March 2000 Ballhausen wrote to Cooper325 advising him of the number of shares purchased and the cost and that the share price was now such that they could be sold on a break even basis. Ballhausen sought Cooper's confirmation to sell. Cooper responded in a letter dated 19 March 2000326 stating as follows:

Dear John ;

Thank you for your memo dated March I. I appreciate it and I am very glad that you have agreed to seek my confirmation before any selling order was placed in the market.

Publicard has substantial upside and is now trading a couple of doll ars over our entry price. I believe in the very near future, we will be b . II . h 32 7 su stantla y m t e money.

Cooper agreed that the effect of his instruction to Ballhausen was to maintain the investment and not sell. 328

228 Home Security i nternational: a case study

2001

Unfortunately, the price of Publicard shares did not recover but fell sharply. On 23 January 2001 Ballhausen learned that HIH had sold its HSI shares to Cooper. He sent an email to Howard and W ein advising them that Cooper owed HIH $944 000 fro m his participation in the Publicard joint venture. 329 Ballhausen requested that the debt be taken into account in any dealings with Cooper. W ein wrote a note on the email to Howard: 'Has this been taken into account?'.

Howard ' s evidence was that he spoke to Cooper about the debt and that Cooper said to him:

It' s got nothing to do with me . Mr Adler just used my name as part of a joint venture and I have no responsibility for it. 33 0

Cooper neither denied nor confirmed that conversation. He said he was always unhappy with the transaction and that it was Adler' s 'problem'. He said Adler had guaranteed his losses which he understood to mean that if there were losses Adler would cover them but if there were profits he, Cooper, would retain them' ?31 I have difficulty with this explanation. It would be surprising if Adler were to enter into an arrangement of that character. In March 2000 Cooper had not disclaimed

involvement in the transaction. The shares had been retained rather than sold on Cooper's express instructions.

Howard then spoke to Adler. Howard claimed that Adler confirmed that the investment had nothing to do with Cooper and that Cooper was simply used as a 'name'. 332 Adler denied making any such comment333 and said that he told Howard that the investment no longer had anything to do with him.334 I accept Adler's evidence on this topic. Given the nature of the relationship between Adler and Cooper in February 2001 it is unlikely that Adler would exonerate Cooper in the manner suggested by Howard.

Howard's evidence was that he did not accept Cooper and Adler's disclaimer of Cooper's involvement in Publicard. 335 Nevertheless, he did not seek to offset the debt against any payment being made to Cooper. 336

Around 26 February 2001 Cooper wrote to Howard seeking to purchase the Publicard shares. The proposal was accepted. On 27 February 2000 Cooper's assistant, Steven Premutico, advised that A$312 000 (US$163 800) was being transferred to HIH to pay for the shares. 337

On 12 March 2001 Cooper wrote to Howard. 338 He referred to his purchase of the Publicard shares and stated that he was shocked to find out that there was 'no market in the stock' .339 On 13 March 2001 Cooper wrote to Howard340 asserting that

an 'error' had been made in the transfer of the $312 000. He claimed that, when reviewing his notes, his assistant had confused US dollars with Australian dollars and he had intended to purchase them for A$163 800 (and not US $163 800). Cooper sought a refund of the difference (A$148 000) or a reversal of the transaction. Howard agreed to the refund. The difference of A$148 000 was repaid on 14 March

The failure of HIH Insurance 229

2001. 341 That was the day prior to the appointment of the provisional liquidator. In explaining why he did this Howard said: 'I had had enough and I gave in'. 342

I find this whole episode bemusing. There was no document which set out the terms of the 'joint venture' between Cooper and FAI Insurances in relation to the Publicard investment despite considerable sums (nearly $3 million) being invested. This allowed Cooper to disclaim liability for the losses or to appropriate any profits depending upon the performance of Publicard's share price. In March 2000 he purported to do the latter and in February 2001 he did the former. The result was that he avoided a liability of at least $944 000. He then sought to take advantage of the low share price of Publicard and to purchase the shares from Howard. When he realised that even that purchase price was too high he again sought to minimise his losses by asserting that there was a mistake and persuading Howard to make a refund. Cooper denied he sought the refund because he found out about the trading price instead asserted it was a genuine error. 343 This is a relatively minor episode but

it demonstrates repeated management failures on the part of HIH.

22.5.1 1 Hemsway loan ($1.5 million debt not pursued)

At some time prior to the F AI takeover, Hemsway Investments Ltd borrowed approximately $1.5 million from F AI New Zealand. The loan was guaranteed by Cooper. 344 From at least September 1999 principal and interest payments under the loan ceased. 345 Cooper asserted that he had reached an agreement with Adler to convert the debt to equity in Vision Publishing.346 Cooper said the conversion never occurred because Williams advised him that he did not want HIH to have 'any equity in any more F AI related companies'. 347 When pressed as to whether he accepted he now had an obligation to pay under the guarantee, Cooper said that during the ' divorce' meeting with Williams, Williams said that the debt would be

'written off.348 Williams told the Commission that he was not even aware of Cooper's indebtedness under the guarantee. 349

I do not accept Cooper's assertion that Williams agreed to write off the debt. Throughout the period November 1999 to March 2001 Cooper wrote many letters about transactions and settlements. If an agreement of the kind he claims had been reached it is likely Cooper would have referred to it in one of the letters.

Howard told the Commission that he had been advised by FAI New Zealand' s general manager, Alistair Richardson, that there was an issue concerning a loan which Cooper had guaranteed and he had a recollection of a suggestion of their being an agreement to convert the debt to equity. 350 Nevertheless, he did not make any inquiries of Williams, Richardson or Fodera during the period from late 2000 to early 2001 to ascertain whether Cooper had any liability and if so what it was. 351 Howard referred to the fact that Williams had never raised the matter with him. Be that as it may, in this period it was Howard and not Williams who was responsible for the distribution and management of HIH's funds in these respects. A simple inquiry as to the extent of Cooper's indebtedness could easily have been made.

230 Home Security International: a case study

22.5.12 The introduction fee ($1.95 million)

It seems that in December 2000 Howard and Cooper had a discussion about the possibility of HIH disposing of all or part of its property portfolio. Howard sent Cooper a note setting out the book values for various HIH properties. 352 Cooper passed it to the Walker Corporation353 but nothing came of it. Howard recalled that Cooper spoke to him in early February 2001 inquiring whether HIH was interested

in selling its entire portfolio as a whole line. 354 Cooper had already approached Tilley with a view to Tilley proposing a deal to the Packer group. 355

Cooper and Tilley met Howard on 14 February 2001 to discuss the proposal. 356 Tilley visited Kerry Packer who was then in hospital. 357 Packer telephoned the chief executive officer of Consolidated Press Holdings (CPH), Ashok Jacob, and requested that he see Tilley to discuss a 'property acquisition' .358 Tilley attended a meeting with Jacob and other executives from CPH. 359

A meeting was arranged involving Howard, Wein, Tilley and CPH executives for 2 March 2001. We in outlined to the meeting the nature of the properties and HIH' s desire for a speedy transaction. Wein explained that there would be a discount from book value of approximately 40 per cent and that CPH would have an option over the portfolio of properties for 14 days. If CPH gave notice within the 14-day period of its desire to acquire them, there would be a 48 -hour settlement period. Either Howard or Wein told the meeting that there could be no 'cherry picking' of the portfolio (that is, se lecting the best value properties and leaving others).360

Late in the afternoon of2 March 2001 there was a meeting of the HIH board.36 1 The minutes noted that Howard informed the meeting that he and Wein had met representatives from the CPH group earlier that afternoon. CPH had requested a '14 day exclusivity period to look at the portfolio' and the ' likely discount on the book value would be between 30 to 40% ' .362

During the week commencing 5 March 2001 CPH instructed lawyers and property analysts. 363 One of CPH's executives inspected the properties on 9 March 2001. 364 He considered that they were of 'a very poor quality' and advised the CPH finance director of his view.365

On 7 March 2001 Cooper sent Howard a fax 366concerning the deal and his fee . It said:

In regards to the interm ediary f ee payable to Mr Tilley and myself of US$2 million + 10% GST. We accept your proposal to slightly restructure the payment formula and confirm th at we will agree today to accept a deposit of $1.5million AUSD to be paid by electronic transfer into the trust account of Brown & Co. This money is to be di vided between Mr Tilley and Brad Cooper after all expenses have been paid ... 367 [emphasis added]

Howard stated this was the first mention of the terms of any fee payable to Tilley or Cooper.368 Cooper asserted that he had a range of discussions with Howard concerning his fee prior to this time, although there was no written agreement. 369

The failure of HIH Insurance 231

Around 8 March 200I, Howard and HIH's solicitors realised that a number of the properties included in the proposal with CPH were subject to the terms of the Allianz trust, thus making it difficult to sell them as part of a disposal of the entire property portfolio.370 This was communicated to CPH and its solicitors. 371

The minutes of a board meeting of HIH held on the evening of Sunday II March 2002 record that the board was advised that the company was negotiating with CPH 'for a minimum purchase of $300 million from the property portfolio'.372 On Monday I2 March 2001, a facsimile 373 (stamped 'draft') was sent to Howard with Ben Tilley's name typed at the bottom and a signature (not his) appended. The facsimile proposed a fee of US$I million for the 'introduction' and 'heads of agreement' with additional payments following sales. This letter and the other letters on the letterhead of Tilley's company, Linkshore Pty Ltd, referred to below, were prepared by Cooper. 374 Howard told the Commission that he advised Wein of this offer and was instructed to go back with a different arrangement. 375 He then wrote a handwritten reply on the fax as follows:

Ben, I do not understand paragraph 2, or where it came from. But HIH are prepared to offer a 2 stage payment of:

I. US$1 million.

2. 1.5% on sales by CPR.

3. Upon agreement of this the list will be forwarded to CPR.

Regards BH.

Howard told the Commission that he addressed the note to 'Ben' because he assumed that Tilley had sent it despite the fact that he was dealing exclusively with Cooper in relation to the fee. 376 Tilley was overseas from 4 March 200I to 16 March 2001. 377 Howard explained that he intended that the payment of 'US$ I million' be payable immediately upon the signing of heads of agreement with CPH. 378

This resulted in Cooper sending a further facsimile379 on the same day (12 March 2001). It proposed a revised fee arrangement of an immediate payment of US$ I million with further payments on exchange and completed sales.

Howard claims that he spoke to Weinand Abbott and then spoke to Cooper. He told Cooper there was 'an in principle agreement to proceed'380 and Cooper advised he would send a further letter. 381 The next day Cooper faxed an invoice 382

and Howard

contacted him to obtain the revised agreement. 383 Cooper sent a further letter dated 13 March 200 I again on Linkshore Pty Ltd letterhead in the name of Ben Tilley. 384

It appears to have been faxed at 1.51 pm. It said, relevantly:

232

At your request I am pleased to confirm that I will accept the following remuneration:

1.

2.

An immediate payment ofUS$1 million.

A further payment of US$250,000 when the sales to the Packer Group exchange on contracts that exceed A$20 million.

Home Security International: a case study

3. A commission of 2.5% on all sales payable to HIH at the time of exchange.

Howard sent the facsimile back at l.09pm on 14 March 2001 385 , signed by himself with the following handwritten annotation:

Agreed with R Wein and C Abbott on Monday at approx 4pm. Further agreed with R Wein at conclusion of audit committee (Tues 13/3/01 6.20pm) mtg at which I detailed that I had negotiated the arrangement from US$1 m + US$1 m to US$1 m + 2.5% effective payment on sales higher than $20 million. R Wein said to sign on his behalf.

Signed W Howard. 386

On the afternoon of 14 March 2001, A$1 965 408 (US$1 million) was paid to Cooper's solicitors' trust account. 387 It was subsequently disbursed to Cooper and Tilley. 388

Kirk Perry, HIH's Treasury accountane89 , told the Commission that on the morning of 14 March 2001 he was advised by Howard of a payment 'that needs to go through today'. 390

There was a significant disagreement between the evidence of Howard, Wein and Abbott as to the circumstances surrounding this payment. I need not resolve all of the differences. I need only note the following.

Abbott denied that he was told that an intermediary fee was to be paid nor that he was advised of the amount of any fee. 391 I do not accept his evidence on this subject. On 24 April 2001 Abbott sent a facsimile to Howard which enclosed a draft letter to Fred Lo. 392 In the draft letter to Lo, Abbott suggested that the minutes of the meeting of the board of 11 March 2001 be amended to note, among other things, that a 'commission fee, was payable to the agent who introduced the deal to CPH on behalf of the company' .393 Abbott's explanation for suggesting this amendment was that he was only seeking to clarify that Weinand Howard had authority to pay the commission fee, that being 'within their authority' ?94 While that may or may not be so, it does not explain why Abbott would suggest board minutes be amended to include a discussion on the payment of the fee, when he denies the discussion occurred.395 I think the better view is that it was discussed then and Abbott was aware of it.

We in told the Commission that during the week of 12 March 2001 he understood that CPH was still 'seriously interested' in pursuing the property deae96 and that the parties were ready to sign a contract 'any day'.397 Wein's recollection was that Howard had told him that the fee would be paid into a lawyer's trust account prior to the signing of an agreement with CPH. 398 It would be refunded if for some reason CPH did not proceed to sign an agreement or complete but would not be refunded if HIH was the cause of an agreement not being signed or completed. 399 Howard stated that he had no recollection of telling W ein this and denied telling W ein or Abbott that payment was to be made into a solicitor's trust account until the property transaction was either entered into or completed.

400 I accept Wein 's evidence on

this. The understanding that Wein said he had of the circumstances in which the

Th e failure of HJH Insurance 233

money would be refunded was similar to the understanding that Howard said he had (although this was not reflected in the terms of the letter that he signed).40 1

I am satisfied that each of Abbott and Wein approved a payment being made when they knew there was no agreement with CPH in place, although to a significant extent they relied on Howard's judgment that the amount and circumstances of the payment were appropriate.

The fact that Howard obtained approval from Wein or Abbott for the payment of the fee on 14 March 2001 did not relieve him of his responsibilities. He was a senior executive. W ein and Abbott had placed trust in him to deal with the issue. He was aware that the introduction had occurred but no agreement had been reached. CPH had never made any statement to him that it was a condition of any negotiation that the fee be paid. CPH had never mentioned the fee at all. There does not appear to be any good commercial reason why such a payment had to be made prior to the entry into an agreement of some kind with CPH. I am satisfied that he did not have an adequate basis to procure its payment.

Once again HIH's funds were disbursed in haste and for little apparent reason. Abbott and Wein's approval of the fee also appears to have been a failing on their part. At the very least they should have insisted that no fee be paid until an agreement was signed with CPH.

22.5.13 The BMW

Sometime in January 2001 Greg MacDonald, the Dealer Principal of Autohaus Classic BMW402, was contacted by a car broker who advised him that Cooper was interested in purchasing an 'X5' BMW. MacDonald located the car and drove it to Cooper who approved it.

Howard told the Commission that sometime in early February 2001 he telephoned Cooper:

because I was going to buy a new car. I was looking- wanted to look at a 3 series BMW and I thought he would be a guy to ring because he seemed to have a lot of fancy cars ... 403

After this call, MacDonald was contacted by Cooper who asked if he could obtain a 'BMW 330i convertible' .404 Cooper telephoned Howard within a few days. He advised Howard that he had obtained a '3 series BMW from Autohaus Parramatta' and would have it brought to the city to inspect. 405 .

MacDonald obtained a convertible and sent it to the city by truck. He recalled meeting Cooper and another person, whom he now believes to be Howard, in the city. 406 MacDonald recalled Cooper ' doing most of the talking' .407 According to MacDonald, Cooper inquired of Howard whether he liked the colour of the vehicle and at some stage there was a discussion about whether a television could be· fitted. 408 MacDonald recalled being asked by Cooper to see if he could obtain a green convertible BMW. 409 MacDonald could not recall being introduced to

234 Home Security International: a case study

Howard. 410 His evidence was that there was nothing said which suggested to him that Howard would be the purchaser. 41 1 Cooper claims he introduced Howard to MacDonald and Howard inspected the car but indicated something was wrong ('wrong colour, wrong car').412 Cooper's evidence was that he organised the

inspection because Howard was 'too busy'.413 Howard recalled Cooper introducing him to MacDonald as an interested purchaser. 414

MacDonald passed on the request to obtain the convertible BMW to his corporate sales manager, Allan Brinck.415 He provided Brinck with the contact details for Steven Premutico, Cooper's personal assistant. 416

On a Saturday shortly prior to 14 February 2001 417 , Brinck took a green BMW 330ci motor vehicle to Howard's home in Hunters Hill. 418 Howard inspected the vehicle and advised Brinck that he was happy with the colour. 419 Brinck recalls Howard then said to him 'That's great; Brad will take care of it for me'.420

Brinck did not obtain any personal details from Howard nor discuss with him how the car was being paid for. Howard recalled telling Brinck that the car was 'fine' except that he wanted a convertible.421 He denied saying to Brinck that 'Brad will take care of it for me'. 422 Howard's evidence was that after Brinck came to his home he spoke to MacDonald in relation to sourcing a demonstration model of a convertible from another dealership423 and the purchase price.424 MacDonald denied that he ever spoke to Howard after delivering a vehicle to Cooper in the city. 425

After meeting Howard, Brinck discussed with Premutico arrangements for the pricing and delivery of the car.426 On 14 February 2001 Brinck prepared a tax invoice427 describing Cooper as the purchaser and sent a facsimile to Premutico enclosing a blank transfer of registration form in order for the purchaser's details to be completed and returned to him. 428 Premutico recalled that Brinck queried the registration details for the car.429 Premutico said that he raised this with Cooper who advised him that it was not confirmed yet but that they would advise Brinck as soon as they could. 43° Cooper could not recall Premutico asking him about the registration details but agreed that if asked, he would have told Premutico he did not know the details. 431

On 28 February 2001 Brinck delivered a green convertible BMW to the offices of FAI Home Security at North Sydney and gave the keys to Premutico. 432 Premutico took the keys and delivered them to Cooper.433 Cooper rang Howard and advised him that the keys were available to be collected.434 Contrary to Premutico's evidence, Howard said that Premutico delivered the car to him in the city, gave him the keys435 and advised him that someone from Autohaus would ring him about payment. 436 He said that Premutico told him that the car was insured. 437

Brinck then had a telephone conversation with Cooper in which Cooper told him he would 'organise to have a cheque sent to you tomorrow'. 43 8 Payment was not received and both Brinck and MacDonald rang Premutico requesting payment. 439 Premutico said he passed these requests on to Cooper who advised him 'We don't know whose name [its] going into, so payment won't be forthcoming' .

440

The failure ofHIH insurance 235

MacDonald also rang Cooper a number of times chasing payment. 441 MacDonald said that Cooper told him 'that he wasn't sure whose name the vehicle was going into, to be sold to, at that stage' .442 Cooper's recollection is different. 443

On 8 March 2001 MacDonald received a cheque444 drawn on FAIHS's Westpac account for $118 636.7 5. This was the exact purchase price for the green convertible BMW. Accompanying the cheque was a note445 advising MacDonald to phone Cooper before he banked the cheque. MacDonald rang Cooper who advised him that the cheque was not to pay for the convertible but was a deposit for the X5 that he was purchasing. 446

Howard said that on about 8 or 10 March 2001 he received a telephone call from Cooper inquiring as to why he had not paid for the car. 447 He denied that Cooper told him then or in any other conversation that a cheque had already been sent for the amount owing on the vehicle. 448 Cooper could not recall telling Howard that either. 449

Sometime later in March 2001 Premutico sent a fax to Brinck advising that the name of ownership for the registration of the vehicle would be 'Mr Bill Howard'.450

Roland Elster, the Autohaus Finance Manager, was advised by either Brinck or MacDonald to contact Howard in relation to the purchase of the motor vehicle which he did. Howard eventually financed the purchase price of $118 637 by entering into an agreement with BMW Finance for $76 000. 451 The remainder was paid by Howard providing a cheque and cash on 21 March 2001. 452

In April 2001, Cooper purchased his X5 motor vehicle by applying the $118 636.75 paid on 8 March 2001 against the purchase price and providing a cheque for the balance. 453

22.6 Conclusion

22.6 .. 1 HIH and HSI-financial impact

FAI's shareholding in HSI as at 30 June 1998 had been booked at an artificially inflated market price of $49.129 million. As at 31 December 1998, just prior to the takeover, the 36 per cent shareholding was valued in F AI' s accounts at $39.573 million. 454 On 8 December 2000 HIH sold its 47 per cent stake in HSI for $1.25 million payable over two years. On the assumption that the $1.25 million would eventually be paid in full by Cooper, HIH incurred a loss on its equity in HSI of no less than $38 million in under two years. Table 22.1 shows the amounts HIH paid out in seeking to control or extricate itself from its relationship with HSI.

236 Home Security International: a case study

Table 22.1 Payments associated with investment in HSI

Nature of payment To whom paid Amount($)

Purchase of further 10% of HSI US shareholders 2126 000

Purchase of 50% of FFC FAIHS (and then to Brown) 13 257 000

Further advance to pay Brown FAIHS (and then to Brown) 531 000

Debt factoring Cerva le Pty Ltd (Cooper) 675 000

Loan in May 2000 FAIHS 5 000 000

Loan on 3 Aug ust 2000 FAIHS 750 000

Loan on 16 August 2000 FAIHS 2 500 000

Cash portion of Ness payment FAIHS 4 500 oooa

Collingwood 'sponsorship' Collingwood Football Club 250 OOOb

Class action costs FAIHS 1 950 000

Further Ness advance FAIHS 2 500 000

Compensation for change in FFC discount rate FAIHS 2 650 000

Tota l 36 700 000

a. The total purchase price was $17 .5 million , but $13 million was used to repay the various loans that were outstanding,

including those noted in the table.

b. This, in effect, being the price paid in order to have Cooper agree to purchase the shareholding for $1.25 million.

After the sale of its HSI shares, all HIH had left of its 'investment' was a further 50 per cent ownership in FPC, a 49 per cent interest in Ness, a 'sponsorship' of the Collingwood Football Club for unspecified benefits and the 'F AI' brand name reclaimed from HSI. The liquidator of HIH sold the 49 per cent interest in Ness for $1 million in 2002.455 There is nothing to suggest that F AI obtained any benefit from its ' sponsorship ' of the Collingwood Football Club.

Table 22.2 shows funds disbursed to Cooper and companies controlled by him in the period December 2000 to March 2001.

Table 22.2 Funds disbursed to Cooper, December 2000 to March 2001

Nature of payment To wh om paid Amount($)

Class action costs FAIHS8 1 950 000

Remaining Ness money FAIHSa 2 500 000

Change in FFC discount rates FAI HSa 2 650 000

Vision Publishing/Goodwill sponsorship Vision/Goodwill 1 937 500

Kirby expenses FAIHS 560 000

Relocation expenses Speakeasy 275 000

Legal expenses FAIHS 92 000

Data Adva ntage FAIHS 1 000 000

Pu bl icard Cooper 148 000

Introduction fee Linkshore (Cooper & Tilley) 1 950 000

Tota l 13 062 500

a. Paid after Cooper acquired HSI's shareholding.

The f ailure ofHIH Insurance 237

In addition to the amounts shown in Table 22.2, the following debts of Cooper were not pursued:

• forgone rental- an unquantified amount owed by Speakeasy

• Publicard- $944 000 owed by Cooper

• Hemsway Guarantee- $! 500 000 owed by Cooper.

It is difficult to see what, if any, benefit HIH obtained from these payments. It is noteworthy that many of them were paid at a time when HIH had cash flo w problems and when the claims of policyholders and other creditors were being deferred.

22.6.2 Williams and the management of HSI

I have set out above a summary of the losses incurred by HIH in its ' management' of HSI through 1999 and 2000. Up until 8 December 2000, the management of HIH's investment in HSI was assumed by Williams. He bears a large measure of responsibility for the losses.

Williams told the Commission that, although his overall object was to dispose of HIH' s involvement in HSI456 , his objective leading up to the FFC acquisition was to minimise HIH 's exposure to the debts owing from HSI and FFC and HIH ' s exposure to Westpac under the securitisation programme for FFC. After the FFC acquisition, Williams said that he was concerned to ensure that HSI did not go into liquidation and thereby affect the 'F AI' brand name and increase the likelihood that HSI's customers would default on their loan obligations. 457 By April 2000 HIH had purchased a further 10 per cent in HSI and the remaining 50 per cent ofFFC. It had thereby gained effective shareholder control of HSI and complete control of its funding arm.

It is difficult to understand why Williams allocated significant monies towards gaining control of both HSI and FFC and then did not seek to exercise it. For example, Williams does not appear to have ever considered seeking to remove Cooper and then commence an orderly run-down of HSI's business and sell off its assets. This would probably have led to losses on book values but may have been preferable to the 'solutions' that were put in place.

This is a case study within HIH that reflects on Williams's management approach. It puts in question Williams's ability to adopt a strategy and . execute it, to make judgments about individuals and to act accordingly. It also gives an insight into the way he approached transactions conferring private benefits of the type I have

discussed. HSI tested Williams and he was found wanting.

238 Home Security International: a case study

22.6.3 Williams and dealings with the board

At the outset of this section of my report I referred to the lack of disclosure to the board in relation to these issues. I should explain this in a little detail.

On 3 June 1999 Richardson provided a status report to the board of HIH on the disposal of non-core assets.458 The board was advised that: 'the sale ofF AI Home Security would take some time. A review was being done on HIH's debt and equity exposure to that subsidiary. '

Williams claimed that he derived his mandate or authority to 'manage' HIH's investment in HSI because, at some point in 1999, it was classified as a 'subsidiary' and thus fell within his management authority.459 This appears to be confirmed by the minutes of the meeting. 460 It is not clear to me how or why this decision was made.

Merely because the management of HIH's investment in HSI was taken out of the hands of the investment committee does not mean the board or a subcommittee should not have been informed of how the 'investment' or 'subsidiary' is proceeding. Yet, the acquisition of a further 10 per cent of HSI, the commitment to

lend funds to pay out Brown, the lending of further funds between May and August 2000 and the Ness acquisition were all implemented without further disclosure to the board. The FFC acquisition was only disclosed after it had occurred. The board had no means of ascertaining what was occurring with HIH's investment in HSI much less any means of assessing the performance of the executives involved in it. It must have been obvious through 1999 and 2000 that HSI was becoming, or had

become, a disaster and the deals being proposed were unusual. In those circumstances the board was entitled to expect full disclosure of all relevant and material matters.

22.6.4 Adler and board disclosure

I have already commented on how Adler referred to himself as HIH's representative on the HSI board. In September 2000 he obtained an indemnity from HIH for being a director of HSI. Yet it is noteworthy that he, like Williams, did not keep the board appraised ofthe deterioration ofHIH's investment in HSI either.

22.6.5 Howard and his dealings with Cooper

From late November 2000 to the appointment of the provisional liquidator on 15 March 2001, Howard assumed the day to day responsibility for dealing with the array of claims that Cooper was making upon HIH. It needs to be remembered that in doing so Howard occupied a very senior position within HIH. From April 1999 to December 2000 he was employed as 'General Manager (Finance)'. 46 1 In December

2000 he was promoted to the position of 'Chief Investments Officer' which involved him assuming responsibility for all HIH's assets.462 Nevertheless, there was, in many respects, a lacuna of responsibility at the level above Howard in this period. Although Wein, MacAdie and, in the case of the introduction fee, Abbott,

Th e failure of HIH Insurance 239

were advised of and in some cases approved the relevant payments Howard bore primary responsibility within HIH for assessing the claims and negotiating with Cooper. Even in those cases where the figure was approved by others, such as the introduction fee, it was obvious that they reposed trust in Howard to assess the claim and negotiate a figure which represented a fair assessment of what the claim was worth and which adequately protected HIH's interests. Howard did not adequately fulfil his duties to HIH.

22.7 Possible contraventions and referrals

In this section I set out the findings I have made about matters that might have been a breach of the law in relation to the subjects considered in this chapter. I also note those matters that, in my opinion, should be referred to ASIC or the DPP, or both, for further consideration.

22.7.1 Arising from Section 22.3.3

Williams If, as I have found, Williams:

• committed HIH to a purchase of Ness Security Products when he either knew or was reckless as to whether the price paid was in excess of its true value

and

• did so with the intention of artificially justifying the book values of HIH's shares and loans with HSI

then, in my view, he might have contravened s. 180(1) of the Corporations Law by failing to act with appropriate care or diligence or he might have contravened s. 182(1) in that he might have used his position improperly to cause detriment to HIH. Further, if he so acted and did so in a manner that might have been reckless as to whether he exercised his power or discharged his duties in good faith and in the best interests of the corporation or for a proper purpose, then he might have contravened s. 184(1).

I recommend that this matter be referred to ASIC for consideration of whether to commence proceedmgs against Williams under any of those provisions.

Adler If, as I have found, Adler:

• used his position as a director of HIH to persuade HIH to enter into the Ness transaction, which he knew to be detrimental to HIH and advantageous to HSI

then, in my view, he might have contravened s. 180(1) of the Corporations Law by failing to act with appropriate care and diligence or he might have contravened

240 Hom e Security International: a case study

s. 182( 1) by improperly using his position to gain an advantage for HSI. Further, if he so acted and did so in a manner that might have been reckless as to whether he exercised his power or discharged his duties in good faith and in the best interests of HIH and for a proper purpose, then he might have contravened s. 184(1 ).

Adler submitted that he could not be found to have breached these provisions because he was only a director of HIH Insurance Limited and the party to the transaction was HIH Casualty and General. In my view, it matters not that the final documentation of the Ness acquisition involved HIH Casualty and General as the purchasing party and not HIH Insurance. Sections 180 to 183 and 184 of the Corporations Law focus on a person making 'use' of their position or exercising the power and duties of the office. I have just commented on how during the negotiation of the Ness transaction Adler used his position as a director of HIH. In those circumstances, the fact that HIH chose to use HIH Casualty and General as the ultimate party to the deal is not an impediment to a contravention being established.

I recommend that these matters be referred to ASIC for consideration of whether to commence proceedings against Adler under any of those provisions.

22.7.2 Arising from Section 22.4.2

Cooper

If, as I have found, Cooper:

• either procured the transfer of $1.12 million from F AI Home Security to one of his private companies or at least decided to retain the funds after they were transferred, either knowing or being reckless as to whether he had any proper entitlement to them

then, in my view, he might have failed in the duties he owed HSI and F AI Home Security. But if he did do so, it would be a duty imposed on him as an officer of those companies, which were not part of the HIH group. I am not satisfied that a referral of this would be within the terms of reference.

22.7.3 Arising from Section 22.5.3

Cooper If, as I have found, Cooper:

• falsely represented to Williams that the Vision Publishing sponsorship commitment was still outstanding, even though he had repaid his debts to F AI Finance Corporation

then, in my view, he might have contravened s. 178BB(l) of the New South Wales Crimes Act 1900 in that he might have made a statement he knew to be false and might have done so with the intention of obtaining a financial advantage for himself.

The failure of HIH Insurance 241

I recommend that this matter be referred to the DPP for consideration of whether criminal charges should be brought against Cooper.

22.7.4 Arising from Section 22.5.4

Howard

If, as I have found, Howard:

• intentionally misled Williams concerning the Goodwill sponsorship when he advised him that it was still outstanding

then, in my view, he might have contravened s. 182(1) or s. 184(2) of the Corporations Law. In respect of the former, he might have improperly used his position to gain an advantage for Cooper; in respect of the latter, he might have used his position dishonestly with the intention of gaining an advantage for Cooper.

Alternatively, if he so acted, he might have contravened s. 178BB(l) of the New South Wales Crimes Act 1900, in that he might have made a statement he knew to be false with the intention of obtaining a financial advantage for Cooper.

I recommend that this matter be referred to the DPP and ASIC for consideration of whether criminal charges or civil penalty proceedings should be brought against Howard.

22.7.5 Arising from Section 22.5.8

Adler As at January 2001 Adler was still a director ofHIH.

If, as I have found, Adler:

• signed the letter dated 2 August 1999 in January 2001 with the knowledge that it was backdated, that it erroneously referred to him as chief executive of F AI and that it was being used to bolster Cooper's claim

then, in my view, he might have contravened s. 182(1) or s. 184(2) of the Corporations Law. In respect of the former he might have improperly used his position to gain an advantage for Cooper; in respect of the latter, he might have used his position dishonestly with the intention of gaining an advantage for Cooper.

Alternatively, if he so acted, he might have contravened s. 178BB(l) of the New South Wales Crimes Act 1900 in that he might have made a statement he knew to be false or misleading with the intention of obtaining a financial advantage for Cooper. A further alternative is that Adler might have contravened s. 300(1) of the Crimes Act, in that he might have made a false instrument with the intention that another

person, Cooper, would use it to induce a third person, HIH, to accept the letter as genuine and, because of that acceptance, to do an act to its prejudice- namely, to pay compensation for the loss of those shares.

242 Home Security International: a case study

I recommend that this matter be referred to the DPP and ASIC for consideration of whether criminal charges or civil penalty proceedings should be brought against Adler.

Cooper

If, as I have found, Cooper:

• knew the letter of 2 August 1999 had been backdated when he submitted it to Howard and added to the misleading impression it created by asserting that it had been 'retrieved from archives'

then, in my view, he might have contravened s. 178BB(l) of the New South Wales Crimes Act 1900 in that he might have published to Howard a statement that he knew to be false or misleading and might have done so with the intention of obtaining a financial advantage for himself.

I recommend that this matter be referred to the DPP for consideration of whether criminal charges or civil penalty proceedings should be brought against Cooper.

22.7.6 Arising from Sections 22.5.9 and 22.5.12

Howard If, as I have found, Howard:

• approved a payment in respect of the Data Advantage claim and procured the payment of the introduction fee without any proper basis

then-depending on whether Howard satisfied the definition of 'officer'-in my view he might have contravened s. 180(1) of the Corporations Law by failing to exercise appropriate care and diligence. In view of the attitude I take to the next matter I decline to make any referral on this.

22.7.7 Arisi ng from Section 22.5.13

Howard Counsel assisting submitted that I should infer that Cooper and Howard entered into an arrangement pursuant to which Cooper would procure or pay for a motor vehicle in return for which Howard would procure the settlement and payment of the various claims that Cooper was pursuing with HIH throughout February and March 2001. Among these claims were the Data Advantage claim and the introduction fee . It was further submitted that in the period between late February and mid-May 2001 Cooper prevaricated, holding the car out as an inducement to Howard to complete

the various deals they were negotiating. It was only when the provisional liquidator was appointed that it was realised that Howard should purchase the motor vehicle.

Howard hotly denied that this inference should be drawn. Howard and Cooper challenged many of the factual matters from which counsel assisting suggested the

The failure of HIH Insurance 243

inference should be drawn. I do not propose to set out in detail the reasoning process behind counsel assisting's submission or the precise detail of Howard's and Cooper's challenges.463 It is sufficient to say that the effect of Howard's evidence was that his contact with Cooper in this respect was opportunistic- Cooper seemed to have lots of ' fancy cars'- and both Howard and Cooper contended that it was always intended that Howard would pay for the car.

Where the evidence of MacDonald, Brinck and Premutico conflicted with that of Cooper or Howard, or both, I have preferred the evidence of MacDonald, Brinck and Premutico simply because they had no self-interest to advance. There are many strange aspects to the entire episode. It seems strange that Howard involved Cooper at all-especially given his evidence that he felt under pressure from Cooper's constant contact with him about ' divorce matters' . It is strange that Cooper would become so involved in the transaction. Cooper's sending to the dealer a cheque in the exact amount of the pmchase price of the car delivered to Howard is noteworthy.

I am mindful of the very serious nature of the submission made against Cooper and Howard. I have also borne in mind here, as in every other instance, that my task is to ascertain whether there might have been a contravention of the law. After giving very careful consideration to all that was put to me by Cooper and by Howard on this subject, I have been persuaded that I ought to draw the inference contended for by counsel assisting. For the limited purpose for which I am required to reach conclusions, I am satisfied that there was an understanding or agreement between Cooper and Howard to the effect that Cooper would procure and pay for the car and Howard would procme the settlement and payment of Cooper's various claims against HIH.

Accordingly, if, as I have found, Howard:

• reached an agreement or understanding with Cooper to the effect I have just described

then he might have contravened s. 182(1) or s. 184(2) of the Corporations Law. In respect of the former, he might have improperly used his position to gain an advantage for Cooper; in respect of the latter, he might have used his position dishonestly with the intention of gaining an advantage for Cooper. Alternatively, he might have contravened s. 249B(l) of the New South Wales Crimes Act 1900, in that it might be inferred that Howard, being an agent of HIH, corruptly agreed to receive from Cooper a benefit- the motor vehicle-on account of either doing an act or showing favour to Cooper in the form of approving or recommending approval of the Data Advantage claim and procuring payment of the introduction fee.

I recommend that this matter be referred to the DPP and ASIC for consideration of whether criminal charges or civil penalty proceedings should be brought against_ Howard.

244 Home Security International:- a case study

Cooper

If, as I have found, Cooper:

• entered into an agreement or understanding with Howard of the kind just described

then , in my view, Cooper might have been knowingly involved in Howard's possible breaches of s. 182(1) or s. 184(2) of the Corporations Law. Alternatively, Cooper might have committed an offence under s. 249B(2) of the New South Wales Crimes Act 1900 in that he might have corruptly given or offered to give to Howard a benefit- being the motor vehicle- as an inducement or reward for Howard doing an act, being the payment or the procurement of the payment of the various claims that related to the business of Howard's employer, HIH.

I recommend that this matter be referred to ASIC and the DPP for consideration of whether criminal charges or civil penalty proceedings should be brought against Cooper.

9

10

II

12

13

14

I S

16

17

18

19

20

HSII.0003.353 at 354.

HSII.0003.353 at 354 to 355 .

HARR.2003 .128.

HARR.2003 .128 .

See HSII.0003 .353 at 366.

HSII.0002.012 at 020.

HSII.0003.353 at 366.

HSII.0003.353 at 366.

HSII.0003 .099 at 106.

See HSII.0012.001.

HSII.0003 .099 at 106 .

HSII.0003 .099 at 106.

FAIB.0016.011.

A copy of the agreement is to be found at HSII.0003.475 at 486.

See HSII.0003.475 at 503.

The warrant is to be found at HSII.0003.475 at 508.

See HSII.0003.475 at 503; The amended agreement also records that Brown received a US$200 000 inducement fee for entering into the amended agreement.

He paid $1 per share for his share in Ness together with $50k for the exercise of the option to acquire the 'financier' (i .e. Vitio' s): HSII.0002.008.

See HSII.0001.054.

See HSII.0001.057 (Australian time) .

The failure ofHIH Insurance 245

21

AARA.0108.0087 at 0094. 22 WITS.0156.001A at 147A par. 6 (Williams). 23

This occurred in April1999 by a series oftransactions described in HSI 's 30 June 1999 SEC return: HSII.0003.353 at 365. 24 AND.l406.0011.0005 at 0007. 25

SBB .088.772_001 ; See also AND.1406.0001.0004 at 0007. 26 See AND.l406.0012.0001. 27

SBB.028 .274 001. 28 AND .1406.0011.0005 at 0007. 29

WITS.0156.001A at 147A par. 6. 30 HSII.0002.0 12. 3 1

HSII.0004.177. 32 HSII.0004.177 at 178. 33

HSII.0004.177 at 179. 34 WITS.0156.001A at 148A (Williams). 35

The cost ofthe shares was US$1.171 million (SBA.152.985_001) with a fee of US$104 000 (SBB.l52.877_001). Using an exchange rate of A$1=US$0.60, the total cost was A$2.126 million . 36

WITS.0156.001A at 148A (Williams). 37 HSII.0006.416. 38

HSII.0006.416at417. 39 HSII.0006.416 at 419. 40

HSII.0006.416at421. 41 SBB.152.887_001 at 887_002 . 42

SBB.152.884_001, HSII.0006.410. 43 SBB.152.835 001. 44

See SBB.152.835 001 at 003. 45 T11787/9. 46

HSII.0006.390. 4 7 HSII.0002.482 at 483. 48

HSII.0003.278 at 297 . 49 HSII.0002.946; the agreement was amended by an 'Agreement to vary Share Sale Agreement' dated 7 April2000 (SBA.188.698_001) and an Escrow agreement

(SBA.257.426_001) which allowed for the release of the deposit to be paid to Brown and the payment of the purchase price in two instalments. 50 See HSII.0002.946 at 947 and 948 and HSII.0002.946 at 947 and 949. 51

SBA.l88.671 001. 52

53

246

See clauses 2 and 3: SBA.188.671_001 at 671_006. SBA.188 .690 001.

Home Security International: a case study

54

HSII.0002 .535 records that as at 30 September 2000 the amount owing was $7.201 million. 55 See SBA.024.985 001 at 002 and the definition of'Term' at SBA.188 .671 001 at - -

671 005 and clause 6 at SBA.188.671 001 at 671 007 . - - -56 SBA.188 .695 001. 57

SBA.188 .685 001. 58 HSII.0039.005 . 59

SUBM.0018.014 par. 3 and SUBM.0018 .014 at 019 to 033. 60 SBA.214.134 001. 61

62

63

SBA.214.132 001.

SBA.214.131 001. SBA.214.131 001 and 131 002. 64 He did not acquire a shareholding until May 2000 Tl6318/56 to Tl6368/58. 65

Tl6251/47 to Tl6251/54. 66 See SBA.214.129_001 ; SBA.214.128_001 and HSII.0006.410. 67

HSII.0029.220. 68 See ADLE.0026.115 . 69

See the deed at SBA.203.676 001 at 676 004 . - -70 See SBB.152.882 _ 001 (The facility was $855 000 and it had a discount of $135 080). 71

See SBA.203 .676 001 at 676 004. - -72 SBB .152.882 001. 73

Tl6256/16 to Tl6256/28. 74 Tl6256/26 . 75

Tl0641139 to Tl0641/54. 76 Tl0640113 to Tl0640/23 . 77

Tl 0640/30 to Tl 0640/36. 78 WITS.Ol56.001A at 148A; see also Tl2499/41 to Tl2499/44. 79

Tl2501/4 to Tl2501/58 and Tl2500/30 to Tl2500/37 . 80 HSII.0002.510. 81

See Tl 0692/3 to Tl 0692/56. 82 Tl 0692/3 to Tl 0693/56. 83

Tl2521/19 to Tl2521/53. 84 Tl2522/5 to Tl2522/9. 85

WITS.0305.001 at 003 to 006 pars 2 to 3. 86 SUBP.0026.001 at 009 to 018 pars 30 to 80. 87

Tl2520/21 to Tl2520/27. 88 Tl2520/29 to Tl2520/35 .

Th e failure of HIH Insurance 247

89

US$2.426 million in September 1998, a US$200 000 introduction fee for the amended agreement, two repayments of US$400 000 in 1999 and the FFC sale proceeds of US$8 .221 million. 90

9 1

92

See HSII.0057 .001.

WITS.0156.001A at 149A to 150A.

ADLE.0026.119. 93 ADLE.0026.114; Tl2530/34 to Tl2530/59 (Williams). 94

Tl2531/3 to Tl2532/ 16. 95

96

97

98

99

HSII.0002.265.

HSII.0002.336.

HSII.0006.442. Tl6281/3 to Tl6282/43 (Adler).

HSII.0002.34 7. 100 HSII.0006.443. 101

SBA.209.461 001. 102 SBA.209.461 001 at461 016. 103

Specifically the F AI Home Securities Sales Rebate Agreement ($4 .067m), the F AI Home Securities Marketing Agreement ($ 1. 75m), the FAI Home Security Overseas Representative Agreement ($1m) and the F AI Home Security Upgrade Monitoring Agreement ($1.3m). 104

SBA.209.461 001 at461 003 . - -105 HSII.0002.327. 106

HSJI.0002.376. 107 HIH.0264.0285. 108

HSII.0002.375. 109 WATS.0005.158. 110

Tl2538/40 to Tl2539/55 (Williams). 111 ADLE.0016.053. 112

HIH.0264.0289 at 0290. 113 See BRD.059.014. 114

BRD.059.000 at 002. 115 BRD.059.000 at 002. 11 6

HSII.0002.356. 117 HSII.0002.356 at 359. 11 8

ADLE.0003.133. 119 SBB .023 .168 001. 120

SBB.023.169 001 at 169 003. - -121 SBB.023 .169 001 at 169 002. - -122 BKEM.0016.615 .

248 Home Security International: a case study

123

HSII.0006.3ll . 124 Tl6291 /22 to Tl6291143 (Adler). 125

HSII.0002.389. 126 HSII.0002.400. 127

See HSII.0002.400 and Tl6294/4 to Tl6295/23 (Adler). 128 HSII.0006.320. 129

HSII.0006.320 at 321. 130 Tl 0317/54 to T1 0318/3 (Howard). 131

Tl0318/41 to T10318/54 (Howard). 132 T1 0318/41 to T1 0318/44; Richardson recalled this meeting occurring on 19 September 2000: T11792/2 to T11972/41. 133

SBB .023.157 001. 134 SBA.072.932_ 001 at 002 (Copy signed by Adler). SBA.024.958_001 at 002 (Copy signed by Williams). 135

SBA.072 .932 001. 136 HIH.0264.0203. 137

SBA.072.902 _ 001 ;T 10323/23 (Howard). 138 HSII.0002.498. 139

See HSII.0010.025 (Shareholders Agreement), SBA.209.452_001 (Share Sales Agreement), SBA.209.457 _001 (vendor warranties in relation to Share Sale Agreement) and SBA.083 .553 _ 001 (Manufacturing Agreement). 140

SBA.083 .553 001. 14 1 DETT.0008.001. 142

See DETT.0008.001 at 012. 143 DETT.0008.001 at 012. 144

DETT.0008.001 at 003 . 145 DETT.0008.001 at 003. 146

DETT.0008.001 at 003. 147 SBA.209.461 001. 148

WITS.0156.001A at 151A. 149 WITS.0156.001A at 151A. 150

Tl2549117 to T12549/24. 151 T12549/26 to T12549/32. 152

See ADLE.0003 .133. 153 HSI1 .0002.400. 154

T16282/16 to Tl6282/1 8. 155 Tl6284/ 10to Tl6284/ 13. 156

T16293/55 to Tl6294/2. 157 Tl6292/2.

Th efailure of HIH Insurance 249

158

Tl6292115 to Tl6292/25. 159 See SUBP.0030.001 at 129 par. 2.2(d). 160

ADLE.0021.029. 16 1 HSII.0006.261 (9 November 2000), SBA.024.982_001 (17 November 2000). 162

T1 0590/41 to Tl 0593 /46 . 163 T10592/47. 164

HSII.0006.276. 165 HSII.0002.536; see also SBA.072.935 001 and SBA.209.433 001. 166

On HSII.0002.536 there is a hand written change making this '250, 6 months 200'. 167 SBA.072.935 001. 168

SBA.209.433 001. 169 Tl0345112 to TI0346/24 . 170

Tl2566/26 to Tl2566/28. 171 Tl2562/6 to Tl2563/56. 172

See SBA.024.962_003 (cheque requisition). 173 SBA.024.962 001. 174

Tl0347/56 to Tl0348/4. 175 Tl0346/58 to Tl0347/3. 176

Tl0347/24 to Tl0348/30 . 177 T I 034 7/56 to Tl 0348/30. 178

Tl2564/23 to Tl2564/32 . 179 Tl0775/47 to Tl0776/5 . 180

Tl 0776/7 to Tl 0776/38 . 18 1 See HSII.0027.013 and HSII.0027.001. 182

HSII.0027.013 . 183 Tl0349/56; BKEM.0030.077 . 184

HSII.0002.592. 185 Tl0351 /5 to Tl0351/25 (Howard). 186

See clause 5.l(a): SBB.020.623_001 at 623_005. 187 See clauses 5.l(b) and 5.2 at SBB.020.623_001 at 623_005. 188

SBA.245.115_001, HSII.0002.590, HSII.0002.617. 189 HSII.0025.001 at 024. 190

HSII.0025.238 at 242. 19 1 Tl0787/6 to Tl0787/ 10. 192

WITS .Ol60.001. 193 WITS.0160.001 at 001 par. 5. 194

WITS.Ol60.006. 195 WITS.Ol60.015.

250 Home Security International: a case study

196

Tl6383/32 to Tl6383/57. 197 HSII.0006.213 at 216 . 198

ADLE.0021.180 at 182. 199 T16421/36 to Tl6421 /55. 200

See SBA.072.991_001; SBA.072.996_001. 201 SBB .023.157 001. 202

See SBA.072 .93 3 001. 203 HSII.0010.025 at 034 . 204

BKEM.0030.077. 205 HSII.0002.569, ROY.0150.0254, SBA.245.114_001. 206

ROY.Ol50.0255 (email to Kirk Perry). 207 Tl0356/5 to Tl0357/5. 208

T1 0365 /40 to Tl 0365 /54. 209 BKEM.0030.076. 210

HSII.0002.617. 21 1 HSII.0002.482 at 483 . 2 12

HSII.0002.514 (12 May 2000); HSII.0035.380 (20 June 2000); HSII.0002.513 ( 16 August 2000). 2 13 HSII.0002.508 . 2 14

HSII.0002.507. 2 15 HIH.0264.0195. 2 16

Tl0339/37 to Tl0339/43 . 2 17 Tl2561157 to Tl2562/4. 2 18

Tl2559/5 to Tl2559/55. 2 19 SBA.071.428 001. 220

SBA.071.424 001. 22 1 HIH.0264.0 186. 222

HIH.0264.0186 at 0188. 223 HSII.0002.613 . 224

HSII.0002.612. 225 Tl 0357/3 to Tl 0358/58. 226

Tl2561139 to Tl2561/55. 227 Tl0362/27 to Tl0362/58. 228

HSII.0002.610. 229 HSII.0002.61 0. 230

HSII.0002.599; Tl0363/33 to Tl0364/13 (Howard). 23 1 Tl0808/9 to Tl0808/32. 232

Tl0808/34 to Tl0808/55 .

The failure of HIH Insurance 251

233

SBA.024.914 001. 23 4 SBA.024.914 001. 235

SBA.024.914 001. 236 SBA.024.914 001 at 914 003. - -237

TJ0372/14 to Tl0372/15. 238 Tl2566/9. 239 TJ0368/48 to Tl0368/58. See also SBA.209.493 001 and TJ0370/2 to T10370/38. 240

Tl1786/20 to Tl1786/35. 24 1 SBA.024.940 001. 242

SBA.024.939 001. 243 Tl0371 /4 to T10371 /58 . 244

HSIL0002.630. 245 HSII.0002.650. 246

SBA.245 .116 001 !ind SBA.210.278 001. - -247 Tl 0367/8 to Tl 0367/53. 248

Tl0372/6 to Tl0373/57. 249 HSII.0002.579. 25 0

HSII.0002.578. 25 1 T10377/5 to T10377/10. 252 HSII.0002.586 suggests it was $240 000. $248 000 is referred to in Cooper' s facsimile

at HSII.0002.573. 253 HSII.0002.573 . 254

HSII.0002 .573. 255 HSII.0002.573. 256

T108!4111 to T10814/18 (Cooper). 257 HSII.0002.581. 258

Tl0378/3 to T10378/4. 259 T10378/20 to T10378/27. 260

T10379/8 to T10379/53 . 26 1 T10817/55 to TI0818/39 (Cooper). See also TI0508/7 to TI0508/21 (Howard). 262 SBA.024.940 001. 263

SBA.024.940 001 at 940 002 . - -264 T10374/24 to Tl0374/27. 265

HSII.0002.644 and SBA.21 0.283 _ 001. 266 T!0375/37 to TI0375/43 (Howard). 267

SBA.024.940 001. 268 SBA.024.943 007. 269

SBA.024.943 008.

252 Home Security International: a case study

270

HSII.0029.293. 27 1 SBB.l52.874 001. 272

SBB.152.874 001. 273 T 16346/4 to T1634611 0. 274

HSII.0029.201. 275 HSII. 002 9.20 1. 276

Tl6346/33 to Tl6346/38 . 277 SBA.024.943 001. 278

SBA.024.943 003. 279 SBA.024.943 _ 004, SBA.024.943 _ 005 , SBA.024.943 _ 007, SBA.024.943 _ 008 , SBA.024.943_009, SBA.024.943_010, SBA.024.943_011, SBA.024.943_012,

SBA.024.943 _013, SBA.024.943_015, SBA.024.943_017, SBA.024.943_018. 280 SBA.024.943 001. 281

HSII.0006.390. 282 SBA.024.943 013 . 283

Tl0609/41 to Tl0609/49. 284 WITS.0195 .001 at 054 par. 219. 285

Tl 0612/7 to Tl 0614/21. 286 Tl0613/31 to Tl0613/36. 287

HSII.0029.010. 288 SBA.024.938 001. 289

SBA.024.938 002. 290 SBA.024.938 002 and HSII.0029.009. 29 1

Tl635118 to Tl6351/16. 292 Tl635118 to Tl6351/46. 293

SBA.024.928 001. 294 Tl0617/36 to Tl0617/47. 295

Tl0617/4 to Tl0617/47. 296 HSII.0006.390. 297

HSII.0006.390. 298 SBA.024.930 001. 299

HSII.0002.644 and see FAIHS, Westpac account; SBA.210.283_001 . 300 See Tl0386/2 to Tl0386/47. 301

Tl0386/49 to T10387/5. 302 WITS.0141.001 at 003 par. 9. 30 3

WITS.0141.001 at 003 par. 10. 304 WITS.Ol41.001 at 003 to 004 pars 12 to 14. 305

Tl0387/2 to T10388/33.

Th e failure of HJH Insurance 253

306

T1 0820/24 toT I 0820/44. 307 WITS.Ol42.001 at 002 par. 5 (Tilley). 308

Tl0393/13 to Tl0393/57. 309 SBA.024.919 003. 3 10

SBA.024.919 006. 3 11 Tl0388/2 to Tl0388/33 . 3 12

Tl0392/l0 to Tl0392/ ll. 313 T l 0392/1 0 to Tl0392/31 ; see HSII.0002.645 . 3 14

WITS.Ol95.001 at 051 par. 200 to 202 (Adler); Tl6230/7 to Tl6230/55 . 3 15 WITS.Ol95 .001 at 051 par. 202 . 3 16

WITS.Ol95.001 at 051 par. 203. 317 HI.0003 .0022.04ll. 3 18

See WITS.Ol46.001 at 007 (Ballhausen). 3 19 SBB.026.274 001. 320

SBB.026.272 001. 321 WITS .Ol46.001 at 008. 322

WITS.Ol95.001 at 053 pars 211to 212 (Adler). 323 WITS .Ol95 .001 at 053 par. 214. 324

WITS .0226.00 1 at 002 . 325 ROY.Ol50.0221 at 0223 . 326

HSII.0024.002. 327 HSII.0024.002 . 328

TI0675/20 to Tl0675/23. 329 SBA.024.93 1 001. 330

Tl0398/30; WITS.Ol95 .001 at 053 (Adler) and WITS .OI46.001 at 002 par. 2 (Ballhausen). 331 TI0677/45 to Tl0677/49 . 332

Tl0398/5 to Tl 0398/50. 333 Tl6233/56 to Tl6234/7. 334

WITS.Ol95 .001 at 053 par. 214. 335 TI 0399/32 to Tl 0399/38 . 336

Tl0398/56 to Tl0399/3. 337 ROY.Ol50.0217 and ROY.OI50.0218 . 338

HSII.0003.575. 339 HSII.0003.575 . 340

ROY .0150.0215. 341 ROY.0150.0213 . 342

Tl0402/38 to 39 .

254 Home Security International: a case study

343

Tl 0678/7 to Tl 0678/54. 344 See Tl0700/28 to Tl0700/57 (Cooper) and SBA.188.493_001. 345

Tl0700/55, SBA.l88.493_001. 346 Tl0701 /2 to Tl0701/36. 347

Tl0702/30. 348 Tl 0703/7 to Tl 0703 /26. 349

T12537119 to Tl2537/26. 350 Tl0409/7 to TI0410/ 13 . 351

Tl0410115 to Tl0410/21. 352 See SBA.316.002 001 at 002 002 . - -353

SBA.316.002 001. 354 Tl0415/37 to Tl0415/41. 355

See WITS.0142.001 at 002 par. 4 (Tilley). 356 Tl0415 to Tl0416 (Howard); WITS .0142.001 at 002 to 003 par. 5 (Tilley). 357

WITS .0142.001 at 004 par. 10. 358 WITS.0142.001 at 004 par. 10. 359

WITS.0142 .001 at 004 par. 11. 360 See WITS.Ol37.001 at 002 par. 5 (Cubbin); WITS.0142.001 at 005 par. 13 (Tilley); WITS .0138.001 at 003 to 004 pars 9 to 14 (Sladden); Tl0419/2 to Tl0419/9 (Howard). 36 1

BRD.070.000. 362 BRD.070.000. 363

See WITS.Ol37.001 at 003 to 004 pars 8 to 12 (Cubbin). 364 WITS .0138.001 at 005 par. 20 (Sladden). 365

WITS .0138.001 at 005 par. 22. 366 HSII.0002.669. 367

HSII.0002.669 at 670 (other versions of this are to be found at HSII.0035.603 and HSII.0035.610). 368 Tl0423/29 to Tl0423/32. 369

Tl0828/7 to T10829110 . 370 See a draft memo prepared by Howard dated 8 March 2001; SBA.173.957 _001 . 37 1

T10425/15 to Tl0425/39 (Howard) and see WITS .0137.001 at 004 par.11 (Cubbin). 372 BRD.074.000 at 000 002. 373

SBA.210.936 001. 374 See Tl 0830111 to Tl 0832/45 . 375

Tl0430/57 to Tl043115 . 376 Tl0431/16 to Tl0431!58. 377

WITS.0142.001 at 006 par. 16. 378 Tl0432/8 to T10432/ 10.

Th e failure ofHIH Insurance 255

379

SBA.210.938 001. 380 Tl0435/ 14toT10435/ 16. 38 1

Tl0435/19 to Tl0435/20. 382 HSII.0002.768; faxed at 1.27pm. 383

Tl 0435/30. 384 HSII.0002. 766. 385

SBA.l51.519 002. 386 HSII.0002.766 at .767 . 387

SBA.210.942 001. 388 WITS .Ol42.001 at 008 to 009 par. 24 (Tilley). 389

See WITS .Ol44.00l. 390 WITS .Ol44.001 at 005 par. 28. 391

WITS.Ol 79.001 at094par.452. 392 SBA.149.945 001 393

SBA.l49.945 001 at 004. 394 WITS .O 179 .00 I at 094 to 095 par. 456. 395

Tl5374/57 to Tl5375/6. 396 Tl4835/25. 397

Tl4836/6 to Tl4836/7. 398 T14837/20 to T14837/58. 399

Tl4838/6 to Tl4838/53 . 400 WITS .0203 .001 at 003 par. 9. 401

See Tl0437/50 to Tl0437/53. 402 WITS .Ol34.001 at 001 par. 1 (MacDonald). Autohaus Classic BMW was the trading

name of Trivett Classic Pty Ltd. 403 Tl0442/35 to T10442/41. 404

SBA.316.004 001. 405 Tl0442/55 to T10442/59. 406

WITS .Ol34.001 at par. 8. 407 Tl0519/l3 to Tl0519/ 14. 408

Tl 0518/49 to Tl 0518/56. 409 Tl0519/6 to Tl0519!14. 410

T10518/29 to Tl0518/35 . 411 Tl0520/48 to Tl0520/59. 4 12

Tl0842/31 to T10842/37. 41 3 Tl0841 / 14 to T10841/24. 4 14

Tl0443/51 to Tl0443/56. 415 Tl0519/30.

256 Home Security international: a case study

416

Tl0521/17 to T10521/19. 417 Most likely Saturday 10 February 2001. 418

WITS.0126.001 at 001 par. 4 (Brinck). 419 WITS.0126.001 at 001 to 002 par. 4. 420

WITS.0126.001 at 002 par. 4. 421 Tl0444/29 to Tl0444/36. 422

Tl 0444/45 to Tl 0444/52 . 423 T10445/3 to Tl0445/5. 424

Tl0445/48. 425 Tl 0529/2 to Tl 0529114 . 426

WITS .0126.001 at 002 par. 5. 42 7 SBA.265 .040 001. 428

SBA.265 .049 _001 ; WITS.0126.001 at 002 to 003 pars 6 and 8. 429 Tl0532/38 to Tl0532/57. 430

Tl0532/45 to TI0532/47. 43 1 Tl0850/5 to Tl0851 /56. 432

WITS .O 126.001 at 003 par. 9 (Brinck); Tl 0531130 (Premutico ). Brinck recorded this in a vehicle delivery acknowledgment form : SBA.265 .051 _ 00 I. 433 Tl053 1/33 to Tl0532/2. 434

Tl0849/30 to Tl0849/33 . 435 T10445/1 0 to Tl0445/38. 436

Tl 0446/24. 437 Tl 0448/36. 438

WITS.0126.001 at 003 to 004 par. 9. Cooper could not recall saying that: Tl 0855 /5. 439 WITS.0126.001 at 004 par. 10 (Brinck) and Tl 0533/25 to Tl0533/40 (Premutico). 440

Tl0533/47 to Tl0533/48. 44 1 WITS .0134.001 at 001 par. 10; Tl0524/5. 442

Tl0524/7 to Tl0524/10. 443 Tl 0856/5 to Tl 0865/8. 444

SBA.210.271 001. 445 SBA.265.050 001. 446

Tl0526/35 to Tl0526/39. 447 Tl0446/5l to Tl0446/54. 448

Tl0452/35 to Tl0452/48. 449 Tl0857/49 to Tl0857/51. 450

SBA .265 .048 001. 451 SBA.324.049 001 . 452

WITS.0143.001 at 003 to 004 par. 8 (Elster); SBA.265 .042_001.

The failure of HIH Insurance 257

453

SBA.194.968 001 and SBA.194.977 001. - -454 SBB.088.772 001. 455

See DETT.0008.001 at 013. 456 WITS .OI56.00IA at 147A. 457

WITS .0156.00IA at 149A to 150A. 458 See minutes at BRD.050.000 at 00 I. 459

See Tl2527/43 to Tl2528/53 (Williams). 460 HIH .Ol88.0001. 461

TI0268/28 to TI0268/34 . 462 Tl0282/57 to TI0283114. 463

SUBM.0018.061 at 105 to 107; SUBP.0049.001 at 029 to 031; SUBP.0031.001 at 045 to 048.

258 Home Security International: a case study

23 Other aspects of the governance of HIH

The governance of HIH has been at the heart of most of the preceding chapters of this report. This chapter provides a more general assessment of the performance of some of the main participants in the governance process. It also deals with other aspects of governance that came to light in the inquiry and have not been addressed elsewhere. It is a gallimaufry of concepts, processes, acts and omissions. The unifying factor is that they all relate to the way in which HIH was governed.

2 3.1 Corporate governance benchmarks

Corporate governance is not a phrase that has a fixed meaning. When used interchangeably with, or conditioned by, the phrase 'best practice' it falls to be addressed having regard to the individual circumstances of the particular company and the sector within which it operates. And best practice may change and develop over time. Accordingly what may be best practice for a junior mineral explorer with a board of three members, all of whom are engaged full time or for a significant percentage of their time on the affairs of the company, may not be so for a large

listed general insurer. Even with the latter, what might have been best practice in say 1995 may not have been so in 2000.

I discussed in Chapter 1 the phrases 'corporate governance', 'corporate governance practices' and 'undesirable corporate governance practices' as used in the terms of reference. Failures of corporate governance may be systemic or they may relate to the way in which specific decisions were reached. This is a distinction that I have made in Chapter 1.

The matters canvassed in evidence occurred between 1995 and 2001. It is not possible to identify a fixed and immutable benchmark of best practice during that period. Inevitably the assessment of impugned systems or conduct will involve judgment. In the absence of a clearly identifiable benchmark there are some general

principles I have used to guide the exercise of that judgment. These principles are canvassed in Chapter 6.

In Chapter 6 I refer in particular to the clarity of the general principles enunciated in the UK Cadbury report. 1 It is apparent that the authors of Australian writings on this subject have found it persuasive? I have had regard to it. Because of the date of issue it can be relied on without fear that there is inappropriate resort to hindsight.

As I have said, the assessment of impugned systems or conduct is a matter of judgment. It depends on the circumstances in which the individual system or action occurred. It will not necessarily depend on what is perceived as best practice in

The failure of HIH Insurance 259

2003 . Not everything that falls short of best practice will necessarily be characterised as an undesirable corporate governance practice within the terms of reference.

It was a constant refrain from the directors that they relied, and were entitled to rely, on management and external advisers and should not be held responsible fo r any deficiencies in the information so obtained. I have set out in Section 6.1 .6 [The non­ executive directors] the principles relating to reliance. An understanding of those principles is important in the discussion of some of the matters that appear in this chapter and elsewhere in the report.

Not everything in respect of which I have felt moved to comment critically in this chapter, and elsewhere, is expressly marked with the epithet of an undesirable corporate governance practice. I did not feel the need to do so . These instances come just as much within the core instruction- circumstances surrounding the failure ofHIH- as they do within paragraph (a)(ii) of the terms of reference.

23.2 T he HIH board

The failure of a company does not in itself establish a failure of governance. But I am satisfied by the evidence before the Commission that there were deficiencies in the governance of HIH which I have no doubt contributed to its failure. Many of those deficiencies are dealt with elsewhere in the report in the context of specific topics. This chapter deals with other aspects of the governance of HIH.

There are three particular areas in which I think the board failed in its stewardship of the company:

• in its decisions on major transactions and acquisitions, which were made without due deliberation or analysis

• in the processes of the audit committee, which operated as no more than an extension of the board meeting and did not give separate, closer consideration to audit issues

• in its apparent failure to appreciate the importance of the group's single biggest liability, its provision for outstanding claims.

The first two of these matters are considered in this chapter. The board's appreciation of its reserves and, in particular, its failure to consider actuarial reports provided to the company is discussed in Chapter 15 .

This chapter also discusses related party transactions involving directors of HIH, instances of misuse of corporate resources and instances of the failure of management to inform the board of important matters. Finally, I discuss two specific transactions which reflect poorly on the corporate culture within HIH. · These are the Pacific Eagle Equities transaction and the $200 million preference share issue in 2000.

260 Other aspects of the governance of HIH

In short, I have concluded that there were many respects in which the governance of HIH was not based on openness, integrity and accountability. Many of the practices uncovered in the Commission's inquiry fell materially short of sensible expectations and would not engender confidence among those who had a stake in the su ccess of the group ' s business.

23.2.1 Meetings of the board

I turn first to consider the processes and operations of the HIH board. The board met quarterly at times set out a year in advance. Typically a meeting lasted half a day or more. 3

Other meetings were called if it was necessary to discuss an issue urgently. 4 From September 2000 meetings were called more frequently to deal with the constantly changing circumstances of HIH. 5

The principal purpose of the quarterly scheduled meetings was to discuss the draft quarterly financial reports. 6 Thus the board' s processes were driven by the timetable for approval of financial reports, as if that were its principal function.

23.2.2 Board composition

Executive and non-executive members As noted in Chapter 6, the Cadbury report describes an effective board as one which combines the intimate knowledge of the business held by the executive directors with the broader view of the non-executive directors under a chair who accepts the duties and responsibilities of his or her post. Cadbury identifies independence of judgment as the essential quality which non-executive directors should bring to the

board ' s deliberations. Apart from their director's fee and shareholdings, they should be independent of management and free from any business or other relationship which could materially interfere with the exercise of their independent judgment. 7 I am wary of attempts at a prescriptive all-embracing definition of 'independence'. Accordingly material such as that contained in the Higg's report can be no more than a guide.

It is not possible to give ' independence' an exact meaning in that context. The crux of my concern is that non-executive directors should be free of any impedient to the exercise of independent judgment. Recently Derek Higgs, in his review of the role and effectiveness of non-executive directors, has nominated circumstances that could affect, or appear to affect, a non-executive director' s judgment. These circumstances include where the director has had a material business relationship with the company in the preceding three years (either directly or as a partner or senior employee of a body that has such a relationship); where the director has received or receives additional remuneration from the company apart from a director' s fee ; and where the director has served on the board for more than ten years. 8 These matters are neither a pre-condition for, nor a guarantee of, an effective

board. But they are instructive.

The failure of HIH Insurance 261

Geoffrey Cohen said that there was a greater proportion of executive directors on the HIH board than on the boards of most other publicly listed companies with which he was familiar. He suggested that this was because Raymond Williams, Terence Cassidy, George Sturesteps and Michael Payne remained directors after th e company was publicly listed in 1992.9 However the real problem with the executive directors on the HIH board was their dominance, not their numbers. This, coupled with the frequent failure of non-executive directors to come to grips with the issues raised for their consideration, stymied the benefits of a unitary board.

At 30 June 1999 the board had 13 directors ofwhom five were executive (Williams, Dominic Fodera, Cassidy, Sturesteps and Randolph Wein) and eight were non­ executive (Cohen, Charles Abbott, Rodney Adler, Justin Gardener, Alexander Gorrie, Neville Head, Payne and Robert Stitt). However Stitt and Cohen, who were also on the board at the time of the float, had served as directors for close to ten years. Stitt had provided legal advice to the group over a lengthy period prior to his appointment. Cohen was a former Andersen partner and had also been a consultant to Andersen following his retirement in August 1990 (although he was not involved in any audit work). When he was appointed as a director of CE Heath, his retainer with Andersen was terminated. After then, Andersen remunerated him on an hourly

basis. They also provided him with professional indemnity insurance cover, an office and secretarial support, personal stationary and reimbursement of some expenses. 1° Cohen also denied the possibility of any conflict of interest in holding the position of chairman of the audit committee whilst also working as a consultant to Andersen. 11

Abbott was receiving additional remuneration apart from his director' s fee (by virtue of his consultancy arrangements), as was Adler. Abbott had also been associated with Winterthur, HIH's major shareholder between 1995 and 1998. Gardener had joined the HIH board immediately after leaving Andersen where he was HIH' s audit partner. And although Payne was then a non-executive director, he had been the managing director in the UK branch for the five years up to June 1998 . Only Gorrie and Head would be considered 'independent', at least according to the criteria nominated by Higgs, and they had both resigned by the end of 1999.

The complexion of the board changed markedly in 2000 following the resignations of Williams, Fodera, Cassidy, Sturesteps and Payne. But senior management continued to maintain a significant presence at board meetings through Fodera and Cassidy, who attended in their capacity as executives.

Influence of senior management One director thought that there was an assumption among non-executive directors, because of the respect they held for management, that a recommendation of management must have been carefully thought out and was almost certain to be correct. He thought that the board was heavily dependent on what senior management thought. 12 Indeed Fodera13 , Sturesteps 14 , Head 15 , Gorrie 16 and Payne 17 could not recall an occasion where the board either rejected or materially changed a proposal put forward by management. Such proposals were always approved by

262 Other asp ects of the governance of HIH

Williams before going to the board. 18 Cassidy could not recall an occasion when a decision was made contrary to the view ofWilliams19, nor could he recall the board rejecting a proposal that Williams promoted.20

The evidence given by the directors was divided as to whether the influence of senior management, in particular Williams, had an adverse effect on the board. Head did not believe that during his time on the board its independence had been compromised by reason of the influence of management. 21 Despite perceiving Williams as a dominating chief executive22 , Stitt maintained that discussion at board level was open and frank. He did not regard the board as a rubber stamp. 23 Gorrie, on the other hand, thought (with hindsight) that the board's independence was compromised by the influence of management in relation to its deliberations.Z 4 So too did Gardener. 25 Abbott agreed that any attempt to oppose the chief executive was ineffective26 and, whilst Payne stated that the board debated suggestions made by Williams, he said that for the most part the board accepted what Williams had put to them. 27

In their submissions, Abbott and Stitt pointed to a number of occasions on which they had disagreed with a management proposal and voiced opposition at board meetings.28 In general, I accept that the board debated issues and that there were instances, albeit limited on the evidence, when the views of board members deviated from those of management. There was also at least one instance where Stitt requested management to undertake further analysis of proposals before the board.Z9 But the fact that debate occurred does not necessarily mean that the requisite

independence and rigour of analysis that is required of a board was practised. I believe that the evidence of Gorrie and Gardener to which I have just described is the best description of the true relationship between senior management and the board. It encapsulates neatly the way practical interaction between the groups operated.

23.2.3 Strategic planning

What is significant, however, is the absence of strategic discussion at board level. The evidence of at least three directors was that there was little, if any, analysis of the future strategy of the company. 30 Indeed, the strategy of the company was not formulated in a document and according to Head, a member of the board would

have had difficulty identifying it. 31

Head said that in his experience it was desirable for a company to have not only an annual budget meeting but also an annual strategy meeting. This would afford management an opportunity to put forward plans for the company's future strategy for board consideration. He said that all future proposals could then be measured against that strategy. He also said that whilst the board discussed strategy, he frequently saw a need for the board to be more proactive, especially having regard to the growth and changes that had taken place in HIH.32

The failure of HIH Insurance 263

Cohen submitted that it was appropriate that management, not the board, propose strategy. Management, he said, is best able to dedicate time to strategic thinking and has the necessary expertise and industry knowledge and experience.33 He submitted that the function of the board is to set goals, that is, to approve the strategy proposed by management and to monitor performance. 34 That may be so, but in approving strategy the board needs to understand, test and endorse it. This is the ke y. Management can propose, but the board must decide. And with something as critical as overall strategy, the board can only decide after rigorous analysis. In monitoring performance, the board needs to measure management proposals by reference to the endorsed strategy, with any deviation in practice being challenged and understood.

Cohen maintained that HIH's strategy was international growth and diversification. 35 But the formulation of strategy requires more than just a broad statement of intended result. Whilst 'international growth and diversification ' may have been a worthy objective, there was no evidence that the board reviewed and tested its appropriateness and how it was to be achieved. Further, strategy needs to be organic and constantly reviewed and updated. It is telling that Cohen submitted that the same 'strategy' was in place at HIH from at least the CIC acquisition in

1995. This suggests to me that the important task identified by Head, namely an annual strategy meeting, was simply overlooked.

Further, it is difficult to see how the board's consideration of any particular management proposal could have been an effective check on management in the absence of any shared understanding of the strategic framework within which the company was working.

23.2.4 Nomination committee

HIH did not have a nomination committee. In the absence of such a committee, it was a critical part of Cohen's role as chairman to maintain a balanced board subject to the approval of shareholders and the views of the existing board. However, the board did not play any part in the nomination of new board members but merely ratified the candidate of Williams's choice. Neither Cohen nor Sturesteps could recall the board ever suggesting an alternative candidate. 36 In approving non­ executive candidates, the board had no guidelines to enable it to assess whether the proposed candidate was genuinely independent. 37 In my view, the board should have actively participated in the nomination of new members and the chairman should have taken the primary responsibility for that process.

Nor, it seems, did the board (at least until the second half of 2000) ever seriously consider whether the ratio of executive to non-executive directors best served the needs of the company. I hasten to say that, in my view, there is no right or wrong model. Some companies will function quite effectively with a board wholly or largely comprised of executives. The point I am making here is that the board did not assess or re-assess whether the way it was constituted enabled it to carry out its . role of stewardship. This is another example of the board not monitoring the effectiveness of its corporate governance model.

264 Oth er asp ects of the governance of HIH

23.2.5 Information provided to board

Cohen considered it part of his responsibility as chairman to ensure that board members had adequate information to discharge their functions. He said he had occasional discussions with management as to what should be contained in the board papers including the extent of financial information, the composition of the agenda and the papers that would be distributed to support the items to be debated. 38

However the HIH board papers and meeting agendas were, in the main, standard documents prepared by the company secretary in a standard format for many years.

Meeting agendas Cohen agreed that, as chairman, he had a general responsibility to oversee the functioning of the board and to ensure that all matters properly to be considered by the board were in fact brought before it. 39 Crucial to this responsibility was control of the agenda. However Frederick Lo, the company secretary, said that the regular board meetings used the same agenda which was created in 1992 upon the listing of the company. 40

The agenda for each meeting was prepared by Lo according to the standard form and forwarded to Cohen for approval. Occasionally, Cohen would contact Lo and ask him to include a particular item or items on the agenda. 41 The agenda would then be forwarded to Williams for comment. 42 It appears other board members did not contribute to the agenda. Gorrie, for example, could not recall the board requesting further matters to be placed on the agenda for the purpose of discussion. 43 Lo could not recall any director other than Cohen or Williams approaching him to put a specific item on the agenda. 44 In the result, the agenda became pro forma and was not a living tool for organising and shaping consideration and review.

Gardener said that he did not believe the agendas were adequate to canvass the matters he believed should be dealt with at board meetings. 45 He thought the agendas tended to be rather procedural in nature, bringing forward items of concern to management but little from outside that source. Head raised similar concerns in May 1999 in a letter to Cohen.46 It appeared to him there were issues to which the

board (as opposed to management) was not directing its attention or sufficient attention. He saw a need for the chair to ensure these issues were put on the agenda to ensure proper focus and an opportunity for board members to contribute their views. He said examples included the fall in share price, capital requirements and a review of the success or otherwise of previous acquisitions. 47

In my view, the agenda for the board was controlled by management and not by the board. This does not properly reflect the true nature and scope of the board's role and nor is it consistent with the board's responsibilities. That is undesirable.

Minutes Lo was responsible for drafting the minutes after each meeting of the board. The draft minutes were forwarded to Cohen for his comments and then circulated to all

The failure of HIH Insurance 265

other directors as part of the board pack for the next meeting. Generally, the minutes were confirmed by the board as a true and correct record.

Cohen stated that the company's practice in relation to minutes was to record resolutions and to note matters formally discussed in short form, rather than to set out in detail all presentations and exchanges which had occurred. He said that not all discussions that took place at board meetings would necessarily be noted in the minutes, but that all material discussions would be recorded. Cohen also said that it would not be uncommon for information to be conveyed to the board 'other than in the context of the board's deliberations ' in relation to a formal resolution. As such discussions would not be required to be formally minuted, it would be possible for them not to be noted in the minutes. The course of debate at meetings of the board was not recorded in the minutes. 48

Board papers The board papers usually included a number of management reports but there do not appear to have been regular reports on strategy, identification and management of risk, corporate governance, performance, succession planning and so on. In May

1999 Head wrote to Cohen saying that the material submitted with the board papers was 'excellent' but was 'not leading the board meetings into discussions on some critical issues nor giving us the necessary material as backing for those discussions'. 49

The information provided to the board was a subject of concern to some directors. Cohen could not recall an occasion upon which he formed the view that material supplied to board members in support of a particular issue was inadequate. 5° Other board members did not feel the same way. Gardener was of the opinion that the reports provided to the board did not adequately analyse the reasons for recommending a certain course of action. In his opinion, the reports did not descend into the detail he considered appropriate given the size and complexity of the company. 51 Adler said that he had concerns as to the quality of information the board was getting from management. He discussed his concerns with Stitt in late 2000. 52

Cohen had concerns that board papers were not circulated as early as they should have been, although this was not an issue raised with him by other directors. 53 Similarly, Stitt said that it was not infrequent for reports which had not previously been circulated to be tabled at a meeting. 54 Cohen said that the timely circulation of board papers became a particularly difficult issue in the last months of the company as board meetings became more frequent and a number of meetings were called outside the normal board cycle. Sometimes these meetings were called at short notice to address specific issues as they arose. 55

Cohen also gave evidence that there had been problems for years with accounting information being readily available to the board. He said that when he voiced his. dissatisfaction, the complexity of the group's operational structure was the reason given by management for the delays. 56 That in itself was an issue which he should

266 Other aspects of the governance of HIH

have taken to the board so that consideration could be given to whether the group's structure was impeding the flow of information and effective management and how those issues should be addressed.

23.2.6 Effectiveness of the chairman

There are other instances of Cohen's failing to act on issues which should have caused him greater concern. He did not bring Williams to account when he bypassed the board in distributing an information memorandum offering the company ' s personal lines for sale. 57 He took no steps to ensure that concerns about governance raised by non-executive directors were dealt with in a proper manner at board level. And he gave little or no consideration to matters which may have raised issues of conflict of interest between directors and the company. These matters are discussed below.

Gardener's letter to Williams Concerns about the governance of HIH were raised by Gardener in May 1999. Gardener was concerned that the board was not dealing appropriately with a number of important strategic issues and was only dealing with issues brought to it by

management. 58 He prepared an analysis of matters for discussion with Williams. 59 The analysis covered the desired mindset of the board; matters to be reviewed with management including HIH's vision, purpose and strategy; oversight of management performance; and accountability.

Gardener met Williams to discuss his concerns on 24 May 1999. 60 Gardener said that Williams glanced at his paper before handing it back with the comment that it was a matter for management, who had things well in hand. Williams said it was agreed that Gardener would wait until the forthcoming budget presentations to see whether the matters raised in his paper were answered.61

Head's letter to Cohen Head wrote to Cohen on 28 May 1999, also raising concerns about HIH' s corporate governance procedures. 62 As noted above, the letter described the board papers as 'excellent' but questioned whether they were leading to discussion of some critical

issues and whether the board was being provided with all the material necessary for informed debate. Head suggested that HIH take greater advantage of the experience of its board members and also suggested appointing a committee to examine the issues raised in the letter. The letter stated:

Let me give you some examples which occur to me from the present Board papers

1) Stating the obvious our shareholders have suffered a serious diminution of value & whereas I am sure Ray & his cohorts are addressing the issue every minute of every day shouldn't we find out whether the Board have anything to contribute & shouldn' t we understand in more detail what management are doing in order to prompt the Board's thinking? What is the extent of our

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shortfall of capital? What are the alternatives in resolving this shortage? Should we be selling unprofitable parts of our business? What is our forecast position on reserves at year end? Does it help to take more reinsurance on Board? Does the F AI merger offer a one off opportunity to improve our balance sheet & give us a flying start for the future? Is there merit in taking on some pain now to bolster our future profitability?

2) There must be more to bench mark our underwriting performance both locally & internationally . . . some of the required increases in reserves stem from problems prior to the current market softens ... I would like to see an analysis of the Company's return on investment . . . What went wrong with our predictions on the reacquisition of the USA Workers Compensation?

3) On this particular occasion I do not feel that I have a sufficient grasp of what is happening in the investment portfolio. Why the reallocation of income? What is the effect of that reallocation on our underwriting performance? Could we have more detail on the strategic investments? ...

Geoff, in essence what I am saying is twofold.

Firstly Ray and his team are a top drawer management Group but we also have on the Board a great deal of experience over a diverse range of activities and the Company should be taking more advantage of that experience.

Secondly, the Board has an obligation to the shareholders to ensure that its modus operandi is suitable to the needs of the business which has, of course, changed dramatically over the past few years. Perhaps the Board should appoint a Committee to examine these issues ...

On a more specific issue I feel uneasy about compressing the Audit Committee and the Board meeting into one afternoon on August 25.

Meeting with the non-executive directors Williams called a meeting of non-executive directors to see whether they had any concerns similar to those raised by Gardener and Head. The meeting was held on l June 1999. Cohen was present at the meeting. Adler and Head (who was away) were not. 63 Gardener said Williams informed the meeting that he was aware of some unhappiness amongst the non-executive directors, mentioning a number of matters raised in Head's letter and also stating that Gardener had some concerns. 64 There also appears to have been some discussion at that meeting about concerns raised by the auditors ( discussed later).

Gardener explained the nature. of his concerns and told those present that he was also concerned about the financial information given to the board. Gardener said Williams asked the other directors whether they agreed with Gardener's comments. All replied that they believed they received the right amount of information and did not want to receive any more. 65 Williams said that he advised those present that a significant proportion of the points raised in Head~s and Gardener~s papers would be addressed at the forthcoming budget presentations. 66

268 Other aspects of the governance of HIH

Williams said the budget presentations took place on 2 and 3 June 1999. Head was not present for those presentations or the board meeting on 3 June 1999. Williams said that at that board meeting, Cohen asked whether Gardener was happy with the responses he had received during the presentations and whether all his issues had been addressed. Williams asserted that Gardener said yes.

67

That evidence was

given to the Commission after Gardener's evidence and has not been responded to by Gardener. While nothing further was done in relation to Gardener's memo, Gardener's concerns persisted. He raised the same matters with Wein upon Wein's appointment as chief executive in late 2000. 68

Gardener's memo was never tabled at a board meeting or given appropriate consideration by the board. 69 It was not circulated or otherwise dealt with in any meaningful way by the board. 70 Yet the memo raised a number of fundamental matters in relation to the operation of the company and it was prepared by Gardener in the belief that the board should consider the weaknesses it identified.

71 A meeting

of some of the non-executive directors was an inappropriate forum in which to debate important matters affecting the company which had been raised by a director. Cohen, as chairman, should have ensured that Gardener's memo was circulated and dealt with in a formal setting.

Meeting with Head

Head was away for the meeting of the board on 3 June 1999. Upon his return he called Cohen and arranged to meet Cohen and Williams on 23 June 1999 to discuss his letter. 72 Head prepared a note of the matters he wished to discuss at the meeting, although the note does not appear to have been provided to Cohen or Williams. 73 Those matters, which developed the issues raised in his letter, included the establishment of a board nomination committee, the convening of a separate annual strategy meeting, giving greater attention to the agenda, review of the audit committee and review of charitable gifts.

Board nomination committee Head said it appeared to him that there had developed an imbalance in the specialised skills of board members. He suggested consideration be given to the appointment of a committee to seek outside professional help on acquiring the desirable variety of skills for the HIH board and the best people available with the desired skills.

74

Separate annual strategy meeting Head said that in his experience it was desirable for a company not only to have an annual budget meeting but also an annual strategy meeting at which management could put forward plans for the company's future strategy for consideration by the board. All future proposals could then be measured against that strategy. He said that the board of HIH discussed strategy frequently but that he saw a need for the board to be more proactive. This was especially so having regard to the growth and changes that had taken place in the affairs of HIH. 75

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Greater attention to the agenda Head said that it appeared to him there were issues to which the board (as opposed to management) were not directing their attention or sufficient attention. He saw a need for the chairman to ensure that these issues were put on the agenda so board members could properly focus their attention on th em and contribute their views. He said examples included the fall in share price, capital requirements and a review of the success or otherwise of previous acquisitions. 76

Review of audit committee Head said that he thought it appropriate that consideration be given to the appointment of another audit partner and also that consideration should be given to replacing the chair of the audit committee. He also said that in order for the audit committee to have time to digest major accounting issues and compliance issue s it was des irable for the audit committee to meet well ahead of the board meeting at which the financial statements were to be considered (rather than meeting on the same day, as was the practice). 77

Charitable Gifts Head said HIH was well known as a major donor to charities. However, it concerned him that the amount being donated had ceased to be appropriate having regard to the company ' s lack lustre performance. 78

Head's decision to resign Head said that at the conclusion of the meeting with Cohen and Williams he had no doubt that they did not intend to pursue his suggestions. Indeed, he considered that there was no prospect that any of his suggestions would be adopted. 79 He gained the impression that neither Cohen nor Williams perceived any need for change. It was obvious they were not prepared to set up a committee as suggested in his letter. He subsequently resigned from the company, in part due to the lack of response to hi s concerns.

Cohen was surprised to receive the letter from Head. He thought that it was appropriate to discuss it with Head and Williams to see what changes could be made to satisfy Head ' s requirements.8° Cohen understood Head to be genuinely concerned by the issues raised in the letter. But apart from convening a meeting with Williams, he had no recollection of any changes having been made to resolve Head 's concerns.81 Cohen agreed that the issues raised by Head were never considered at a full board meeting. 82

Cohen suggested to Williams that one way of addressing Head's concerns might be to hold strategy meetings at which strategic issues could be presented to the board . 83 Williams did not embrace that idea and it lapsed. 84 Cohen conceded that whilst his suggestion was constructive, as Williams had said 'no' that was the end of the matter. 85 Cohen agreed the capacity of the board to consider and debate major strategic issues confronting the company was an important issue and that was the very issue Head raised in his letter. 86

270 Other aspects of the governance of HIH

Head's concerns were astute and well-reasoned. Cohen should have acted on them. On what was known then Cohen should have appreciated the emerging issues were serious. The evidence established that Cohen was not prepared to raise matters at board level which did not have Williams's imprimatur. Indeed Cohen's evidence was that although he believed strategy meetings were appropriate, he did not take the matter any further because Williams did not embrace the idea. That attitude displays a misconception of his role and duties as chairman.

Williams's response to Head's concerns was also unsatisfactory. The issues he raised were serious matters which should have been the subject of full debate at board level rather than being dealt with in a dismissive way.

Head's concerns should not have been dismissed summarily in the way they were. This was a lost opportunity for HIH, in June 1999, to have grasped the nettle and to have come to grips with what by then were or should have been recognised as serious management problems.

Conflicts of interest Cohen agreed that, as chairman, he had a responsibility to draw to the board's attention any conflict of interest of which he became aware. He said this had happened on one occasion that he could recall: when he raised the issue of notes to the account disclosing the policies that particular directors had with the company. 87 Cohen said any matter involving a possible conflict of interest ought to be brought to the attention of the board so that the board could take appropriate steps to ensure that all proper safeguards were put in place to protect the company. He said this was because of the heightened dangers arising from a conflict of interest. 88 Cohen did not think he had any particular role to play in identifying circumstances that posed a conflict of interest except to the extent that he knew the secretary was receiving reports from directors as to their other interests and tabling them. He thought it was the responsibility of each of the directors to declare any conflict of interest they may have had. 89

The absence of disclosure by board members did not in itself permit Cohen to assume there was no conflict of interest in a transaction. Nor do I accept the submission that if disclosures of interest were required by law and not made, the absence of disclosure was a matter exclusively for the director concerned. 90 That displays an abdication of Cohen's responsibility for taking the lead in securing full disclosure by all directors. I regard this as a key part of the chair's role. Avoidance of conflicts goes to the very integrity of the board's processes.

To my mind this is a particularly important issue. It is not solely the fault of Cohen. As will be seen later in this chapter, related party transactions were not uncommon in the life of HIH. Nor was HIH immune to the problems that will usually attend them. The board should have ensured that proper procedures were in place to

identify and resolve problem areas in relation to conflicts. They did not do so.

Taking all of these matters into account I am drawn to the conclusion that Cohen was ineffective in his role as chairman. Given the critical importance of this office,

Th e failure of HIH Insurance 271

Cohen's performance in this regard was a grave impediment to the proper functioning of the board.

23.2.7 Accountability

HIH had limited guidelines and processes in place to hold staff, management and executives accountable. To the extent that such guidelines were in place, they related to underwriting9 1 and administrative matters.92

The level of authority held by executive directors was not defined. There was no evidence of full and proper consideration by the board of either Williams's level of authority93 or that of any other board member. 94 Williams said that as the organisation grew matters such as demarcation of responsibilities, accountability, areas of discretion and the like took place without the need for them to be put in writing. People understood what needed to be done. He said those matters evolved out of people working together without the need for documents. He denied there was an insufficient knowledge at various levels within the group as to lines of demarcation, areas of discretion and what the limits of discretion were. 95

Similarly, key performance indicators for executives were not defined. There was no formal process in place for reviewing the performance of the executive directors.96 Stitt said that the human resources committee would discuss the performance of the executive directors and that all of the executive directors were put under the microscope. 97 However, he was not aware of any key performance indicators being identified for the performance of those executives. 98 Without criteria against which to assess their performance, it is difficult to see what this process could have achieved.

Williams agreed that there was never an independent review of the organisational structure within HJH.99 He also agreed that no consideration was ever given at board level to the appointment of consultants to undertake an independent review of the organisational structure. 100 There was no independent review of the efficiency of the organisational structure, , nor any independent review of the adequacy of the reporting lines which the company had in place. 101 The board did not engage consultants to assist in reviewing the operations of the group until late 2000 or early 2001 .102 Williams said no consideration was ever given by the board to engaging consultants to benchmark or review the board's own performance. 103

The board' s failure to monitor systematically the performance of management and executive directors was a reflection of its wider failure to hold executives to account in the interests of the company and its shareholders. Such a lapse might have been identified had the board commissioned a review of its own role and performance.

272 Other aspects of the governance of HIH

23.3 Decisions on major transactions

Decisions on significant proposals were often made by the board on short notice with insufficient information and without adequate analysis of the impact of the decisions being made. This was often a result of the board accepting the views of management uncritically. Examples include the opening of the UK branch, the reacquisition of CareAmerica, the F AI acquisition and the Allianz transaction. Each of these topics is considered in detail elsewhere. This section deals with them from a governance perspective.

23.3.1 Opening the UK branch 104

Following his retirement from Lloyd's in 1992, Payne joined the HIH board as a non-executive director. In the first half of 1993 Williams asked him to set up a branch office in London. Payne agreed and took up the position of executive director for the UK operations and subsequently became chief executive of HIH (UK) Limited. 105 Payne agreed that it was Williams who wanted to open a UK branch and have Payne appointed as its chief executive. 106

Payne's appointment was a decision made by the board on Williams's

recommendation. No other applicants were sought. 107 Williams said that his friendship with Payne had nothing to do with the business aspect of Payne' s appointment. He said Payne was a very experienced underwriter and had a tremendous reputation in the London market. 108

The board minutes in the first half of 1993 do not disclose any consideration by the board as to whether the opening of a branch in the UK was compatible with HIH's broader strategy. There was no evidence that the board contributed to the development of a business plan for the new branch. That complacency by the board when HIH was entering unfamiliar territory, namely the UK insurance market, was

inappropriate.

23.3.2 Repurchase of CareAmerica 109

At a meeting on 13 December 1996 the board considered the proposal that HIH reacquire its old Heath Cal business, CareAmerica Compensation and Liability Insurance Company, a California-based company that it had sold in 1994. 110

Williams tabled a briefing paper prepared by Hambros sourced from both an information memorandum prepared by Dean Witter Reynolds Inc and from Hambros' discussions with CareAmerica management. The briefing paper emphasised that the information it contained had not been independently verified and that further due diligence would be required if the transaction was to proceed.

111

This was of particular importance in relation to the five year profit forecast model (and the assumptions upon which it was based) produced by CareAmerica senior d

0

d 0

h b 0

fi 11 2 management an contame m t e ne mg paper.

The f ailure of H!H Insurance 273

A summary of offer letter prepared by Hambros and also tabled at the meeting proposed that HIH not seek a reserve indemnity for the two years between the sale and reacquisition of CareAmerica. This would result in a reduction in the purchase price of between US$3 million and US$5 million. If a reserve indemnity was not

sought, it stated that a full due diligence would be completed on loss reserves.11 3

The board subsequently gave approval for Williams to enter into negotiations to reacquire CareAmerica for no more than US$67 million. 114

An actuarial review of CareAmerica's reserves was undertaken by Timothy Perr of Timothy B Perr & Company. Rather than commission an actuarial analysis from scratch, Perr was retained to perform a 'desktop review' of a recent actuarial report prepared on behalf of CareAmerica by Milliman & Robertson. 115 The source material was not analysed by Perr to determine whether the reserves were appropriate. 11 6

A financial due diligence report on CareAmerica was prepared by Andersen.11 7 Andersen reviewed the five year profit forecast as part of the financial due diligence. But the review only went so far as to test the mathematical accuracy of the model on which the forecast was based and to confirm that the model ' s assumptions were used to compute the mathematical results. 11 8 The assumptions themselves were not otherwise tested for reasonableness. Such testing did not fall within the scope of Andersen's retainer.

The reports prepared by Perr and Andersen were tabled at a board meeting on 27 December 1996. 119 The reviews performed by Perr and Andersen fell short of the full due diligence recommended in the Hambros paper. This was not disclosed to the board and it seems the board did not even notice. The board did not heed the recommendation in the Hambros briefing paper that full due diligence be performed. Nor did the board pay sufficient attention to the fact that the absence of a reserve indemnity would expose the company to a risk of loss. Instead the board simply accepted management's assertions that re-entry into the US market was at the bottom of the cycle without subjecting those assertions to appropriate and vigorous analysis.

23.3.3 FAI acquisition 120

The HIH board met to discuss the acquisition ofF AI on 22 September 1998. The notice of meeting was circulated earlier that day and called for a meeting of the board at 6 pm.12 1 An interesting aside to the 22 September 2000 meeting is that Erwin Heri was not present and did not receive notice of the meeting. Heri believed that he resigned from the board on 28 August 2000. 122 Yet the company records made available to the Commission show his date of resignation as 15 October 2000. 123 Because of the late notice, a number of directors were not present. Payne, Cassidy, Weinand Sturesteps 124 were overseas. Only three directors were present in person in Sydney, namely Fodera, Head and Williams. Four other directors participated by video, namely Abbott, Gorrie, Cohen and Stitt. 125 Gorrie said that

274 Other aspects of the governance of HI H

those participating by video did not have a copy of the report prepared by Hambros which provided details of the proposed acquisition and was discussed at the meeting. Gorrie recalled receiving a copy in the post shortly afterwards. 126 Cohen did not recall receiving a copy of the Hambros financial model until the day following the board meeting 127 but believed that parts of the document were faxed to Abbott, Gorrie and him at the HIH Melbourne office either before or during the course of the 22 September meeting. 12 8

The meeting was told that there were other parties interested in acqumng a shareholding in F AI and it was in that context that the meeting proceeded urgently to consider the acquisition.129

Prior to the meeting, the acquisition ofF AI had not been formally discussed since the board meeting on 27 February 1998, some seven months earlier. 130 On that occasion Williams advised the board that the proposal to acquire F AI had come to a halt because Adler did not want to dispose of his shareholding. 131 Abbott said it was quite possible he first knew of the renewed move to acquire F AI when he attended the video faci lity in Melbourne for the purpose of the meeting. 132 Similarly, Gorrie was unable to recall if he was told the purpose of the meeting prior to his attendance. 13 3

At the start of the meeting Cohen queried whether there was any legal impediment to the meeting proceeding if some directors had not received notice. He also raised the question as to whether it was appropriate to consider the matters on the agenda in the absence of those directors. Cohen recalled being advised there was no legal impediment to proceeding, although he could not recall from whom that advice was received. He said that no one at the meeting suggested it was inappropriate for those present to approve the acquisition in the absence of the other directors.

Cohen was right to question whether the meeting should proceed. However, he should not have accepted a bald assertion that the meeting could proceed without testing it and ensuring that the basis of the advice was recorded in the minutes. The meeting had been convened without appropriate notice to discuss a significant acquisition which had not been an agenda item for some months. The directors could not have been expected to give due consideration to the details of the acquisition. A number of the directors had no notice of the meeting at all. Others may not have had the appropriate documentation in front of them during critical discussions. The suggestion of competition with another potential bidder was not a justification for ignoring due process.

This was yet another example of management pursuing an objective without regard to the role of the board. The board was given no notice that the acquisition was imminent. It was not informed that negotiations with F AI were at a critical point until the day it was required to make a decision. Payne got notice of the meeting after it occurred due to the time difference in the UK. His response to the suggestion that he was entitled to express a view as to the acquisition was telling:

Th e failure of HIH Insurance 275

Well, l knew he wanted to buy it. I knew why he wanted to buy it. The board minute approving it was just setting a rubber stamp on it and it was signed and sealed. I didn ' t think it was necessary to raise any further queries at that time. 134

The F AI acquisition provides a clear example of failure on the part of those board members who were present properly to discharge their duties to the company. They should have insisted on more time to assess and deliberate on the decision.

23.3.4 Allianz joint-venture 135

In July 2000 an information memorandum was distributed to a limited number of parties who had expressed an interest in entering into a joint venture with HIH in relation to retail insurance business. 136 The creation and distribution of the information memorandum was unsatisfactory in two respects. First, a joint venture of HIH's retail insurance business was not a matter which had been raised or canvassed at board level. Second, the board did not approve the contents of the

information memorandum or its distribution. Indeed, the existence of the information memorandum was not made known to some board members until a board meeting on 5 September 2000, by which time various offers had been received and negotiations with interested parties were well underway.

Williams agreed that the board itself had made no strategic decision to find a joint­ venture partner for HIH 's retail insurance business. He said that management was gauging interest from other parties on the basis that the results of the process would then be presented to the board. He said however that he arranged a board dinner on

17 July 2000 to discuss alternative proposals for the disposal of parts of the personal lines business. He said this followed on from the board's knowledge that the company was conducting a strategic review of all businesses to deal with the impending APRA guidelines and the inability to raise capital from the market. 13 7 The dinner was attended by Williams, Fodera, Gardener, Cassidy, Cohen, Stitt and Sturesteps. Abbott, Adler and W ein were not present.

In my view, an informal dinner meeting was clearly an inadequate forum to deal with important matters going to the future strategic direction of the company and the disposal of one of its most profitable lines of business. While the issues might have been broached at such a meeting, they called for more detailed elaboration and deliberation. This is particularly the case given that some directors were not present at the dinner and were not otherwise advised of the discussions which took place at the dinner.

In Chapter 17 I have described in some detail the involvement (or lack of involvement) of the board in what was to become the Allianz joint venture before 5 September 2000. But because it is, to my mind, such an extraordinary episode and has so much to say about the management of HIH I will repeat some of what I have already said.

276 Other aspects of the governance of HIH

Of the non-executive directors who attended the dinner, Cohen said he was told that an information memorandum had been distributed to selected tenderers. But Cohen could not recall whether he was told this shortly before or after the event. He said it was possible that it had been distributed before he even knew of the management proposal to sell these lines of business. 138 Cohen agreed that the possibility that an

information memorandum had been distributed inviting parties to tender for the personal lines of business before the board was aware of the proposal was extraordinary. He also agreed there should have been a full and reasoned consideration of the issue by the entire board and a resolution to solicit those offers

before this step was taken. 139

Stitt said that although he had attended the dinner on 17 July, nobody had said anything to him of the proposal at that dinner. He first became aware of it on 5 September. 140 He recalled that he was dissatisfied as to the state of play as at the meeting on that date and he wasn't prepared to continue. 141

Gardener said he was surprised to learn negotiations were on foot with four parties interested in purchasing the retail divisions of the group when he attended the 5 September meeting. 142 Gardener's surprise suggests he was otherwise unaware of the proposed sale.

Adler said he first learned ofthe issue of the information memorandum in mid-2000 through third parties in the insurance industry. Adler subsequently contacted Williams and recommended that he advise the board of the distribution of the information memorandum. Williams declined Adler's request to be provided with the memorandum, saying that Adler would 'eventually get it'. 143 Abbott only found out about the proposed joint venture in August 2000 when he raised a query about the capital raising in Asia. 144 He was concerned that the proposal had reached a stage where an information memorandum had been issued and responses were being sought before he as a director knew about it.

145 Abbott expressed his concerns in a

letter to the chairman in October 2000. 146

The Allianz transaction represented a profound change in the strategic direction of HIH. It is simply extraordinary that management pursued a change of that character without even informing the board, let alone putting forward a proposal. Adler was right to draw that matter to Williams's attention. The way this transaction was handled illustrates the narrow view management held of the board's role. Further, the board apparently was prepared to accept such a role. That the information

memorandum was distributed without board approval was a clear sign that management misconceived the true extent of their proper authority. The board should have reprimanded management for distributing the information memorandum without board approval.

The only director who appears to have even raised the need for further analysis of the various proposals was Stitt. This highlights the failure of the board members themselves to understand their role. As a result, the board effectively abrogated its functions.

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23.3.5 Other transactions

There are other examples where the board failed to appreciate the full implications of complex but important transactions. One of them involves the letters of credit issued by Westpac and SocGen to support the Cotesworth operations in Lloyd's syndicates. This is discussed in detail in Chapter 19. Another example is the total return swap agreement that was part of the financial arrangements for the F AI acquisition. It is discussed in detail in Chapter 14.

In both cases the board appears not to have appreciated the terms and conditions of the arrangements or the impact they might have on, for example, the obligations of the authorised insurers to the regulators.

In those instances, it is not clear whether the problem was due to management's failure to draw an important matter to the board's attention or whether there was a failure on the part of the board to assess the information provided. I make no adverse comment about the board in this respect but it is another illustration of a systemic issue concerning management and the board.

23.4 Audit committee