Hanover Finance is an absolute disgrace and a dreadful indictment of the country's capital markets.

Investors in the company have been slam-dunked and a number of individuals, including shareholders Mark Hotchin and Eric Watson, chairman Greg Muir, front man Richard Long and Securities Commission chairwoman Jane Diplock, have a large number of questions to answer.

Why were Hotchin and Watson allowed to obtain huge related party loans from Hanover?

What role did Muir play in terms of corporate governance and how much was he paid?

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Why did Muir and his fellow directors allow the company to pay huge dividends when its balance sheet was contracting sharply?

Did Long have a clear understanding of the company he was aggressively promoting to the public?

Why didn't Diplock insist that Hanover, which was one of the country's largest finance companies, have better prospectus disclosure standards?

Why isn't she demanding the shareholders pay back the dividends distributed in the June 2008 year?

Hanover investors must now decide whether to approve the debt restructuring proposal or put the company into receivership. This is a difficult decision because the management team that made a mess of the company will remain in charge and investors have as much chance of getting all their money back as the All Whites have of winning the 2010 World Cup.

Unfortunately, Hanover Finance is yet another example of woeful corporate governance and inadequate disclosure that has destroyed confidence in our capital markets.

The ultimate parent of Hanover Finance is Hanover Group, which is owned by Hotchin and Watson. Hanover Finance owns 100 per cent of United Finance, which is also the subject of a debt restructuring proposal.

Hanover Finance relied heavily on Long, the former television newsreader, to attract investors through an extensive TV and print advertising campaign.

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Hanover's prospectuses were notable for the important information they failed to disclose.

The Long advertising strategy was highly successful and at the end of the June 2006 year the company had total assets of more than $1 billion and was ranked number one in terms of total assets and net profit after tax in the KPMG Property Development and Commercial Finance category.

As the accompanying table shows, there were two important features regarding Hanover, the huge amount of related party loans and enormous dividend payments.

Related party loans were a huge $199.5 million or 19.5 per cent of assets as at June 2006 and stood at $85.4 million or 14.9 per cent of assets at the end of the June 2008 year.

A high percentage of the June 2008 loans were to Hotchin and Watson companies that own Stage One and Stage Two lots at Jack's Point in Queenstown.

These loans, which have a capitalised interest facility, rank behind first ranking mortgages held by banks. PricewaterhouseCoopers (PWC) believes the current value of these Jack's Point loans "would be significantly less than the book value".

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One of the problems with related party arrangements is that borrowers may repay loans associated with profitable assets but pass on losses associated with poorly performing assets to the lender.

Hanover Finance paid dividends of $86.5 million in the two years ended June 2008 even though it had net earnings of only $54.3 million during this period. It paid a $28 million dividend for the July-December 2007 period when total assets fell from $961.2 million to $796.7 million and a further dividend of $17.5 million for the January-June 2008 period when total assets plunged from $796.7 million to $573.9 million and it recorded a net loss of $4 million.

How can the company justify these huge dividends when its deposit base was haemorrhaging and its profitability plunging? PWC said $5.5 million was distributed in June 2008, just weeks before the company suspended interest and principal payments, but "the minutes of board meetings confirm that all distributions during the period reviewed were supported by consideration of solvency and a formal board solvency certificate was prepared".

How could the board, which consisted of Muir, Hotchin, Sir Tipene O'Regan and Bruce Gordon (the latter two resigned on October 30), justify these huge dividends when it was patently clear that Hanover Finance was experiencing major liquidity problems? The Explanatory Memorandum for the December 9 meeting to approve the debt restructuring proposal is like all of Hanover's documents - it is complex, difficult to understand and omits some of the more important information.

For example, it includes only a summary of the PWC analysis, whereas the full report contains much clearer details of the huge dividend payments and related party loans.

The full PWC report also contained the following information that should have been included in prospectuses:

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* 93 per cent of loans were on a capitalised interest basis, with only 7 per cent paying interest.

* 39 per cent of total lending was on land banks.

* Only 36 per cent of loans were first mortgages.

* A large number of investors may not have invested in Hanover Finance if these numbers had been disclosed in prospectuses.

* The proposed debt restructure has two main features:

* Hanover Finance's shareholders will provide $10 million of cash immediately and up to an additional $20 million at a later date.

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* Investors will receive 8 per cent of their money back next year, 10 per cent the following year, 12 per cent in 2011 and 35 per cent each in 2012 and 2013.

There is no provision for any interest payments and future related party loans are not prohibited under the proposal.

A $26 million subordinated advance is not important because the money goes out as soon as it comes in and the transfer of $40 million of assets from Hotchin and Watson is not considered to be material because these properties are probably overvalued and will be difficult to realise.

The proposal is an insult to Hanover Finance investors.

The company paid dividends of $45.5 million in the June 2008 year, yet the two shareholders are only willing to contribute $10 million to stave off receivership. According to the Explanatory Memorandum the directors spent six months before July 23 this year trying to diversify the company's funding base but were unable to do so because "of deteriorating global financial services market conditions and a softening property sector both in New Zealand and offshore".

This procedure was a farce because retained earnings are one of the best forms of alternative funding and if Hotchin and Watson were serious about developing alternative funding then the company should have stopped paying dividends.

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Hanover Finance investors face a very difficult decision at the extraordinary meeting in Auckland on December 9.

Muir and Hotchin, the only remaining directors, are recommending that investors vote in favour of the proposal. Muir is leaving the leaking ship early next year to become chief executive of Tru-Test.

PWC believes "the debt restructuring proposal offers Hanover Finance secured depositors a greater prospect of recovering all or a large part of their investment compared to an immediate receivership" while the trustee, Guardian Trust, has not made a recommendation.

PWC may be right but, based on past experience, it is difficult to believe that Hotchin and Watson will put the interests of investors ahead of their own.

With this in mind, receivership may be a better alternative and if a trading bank, rather than individual investors, were owed money by Hanover Finance then it would almost certainly prefer the receivership option to a continuation of the Hotchin and Watson controlled governance regime.

Disclosure of interest; Brian Gaynor is an executive director of Milford Asset Management.
bgaynor@milfordasset.com

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Correction, clarification and apology
A column entitled "Hanover's Shameful Slam-Dunking" dated 29 November 2008 asserted that Hanover's prospectus should have included information that most of Hanover's loans were second mortgages and that interest on loans was capitalised. Another entitled "Hanover Debacle Must be Turning Point" dated 6 December 2008 asserted that Hanover adopted misleading accounting policies in relation to capitalised loans. The Herald accepts that Hanover's prospectus No. 36 accurately disclosed on pages 55-61 that most of Hanover's loans were second mortgages and that the interest on the loans was capitalised, and retracts and apologises for the suggestion that Hanover misled or withheld information from the public as to the nature of its lending.

Articles entitled "Hanover House of Cards Doomed to Fail" dated 6 March 2010 and "Mark Hotchin: The Man Behind the Money" dated 19 February 2011 asserted that Hanover declared dividends out of non-cash profits, and an article entitled "Brian Gaynor: Message to Hotchin - own up or shut up" asserted that those dividend payments should not have been made. The first two of these articles also asserted that Hanover was, in effect, operated like a Ponzi scheme. The Herald acknowledges that Hanover was not a Ponzi scheme, and that Mr Hotchin did not act illegally in receiving dividends from Hanover, and apologises if any readers took those messages from these articles. The main purpose of all of these articles was to call for greater regulation of the finance industry.