Brian Gaynor: Hanover debacle must be turning point

Brian Gaynor

It is great to see next week's Hanover Finance debt restructuring meeting getting plenty of publicity. This is because there needs to be a serious debate about many of the company's activities, including the absence of strong independent directors, huge related party loans, massive dividend payments and misleading accounting policies.

It is essential that the Hanover Finance debacle is a turning point as far as the country's capital markets are concerned because if many of its activities are not restricted or banned then investors will continue to have little confidence in our capital markets.

One of the most important features of Hanover Finance is that it makes most of its loans to property developers. These are mainly second and third mortgages with 93 per cent of the loans having capitalised interest characteristics.

A capitalised loan is where the interest is added to the principal instead of being paid. For example if a developer has a $10 million loan from Hanover with an interest rate of 15 per cent per annum then the annual interest of $1.5 million is added to the $10 million at the end of the year. Thus the loan becomes $11.5 million.

These capitalised loans play an important role in the related party transactions and dividend payments while their accounting treatment has given the impression that Hanover was performing far better than it actually was.

For example Hanover's accounts for the year ended June 30, 2008 showed that the company received interest income of $101.2 million whereas the actual amount was probably more like $10 million.

One would have expected the Statement of Cash Flows to show the true interest total but it also had a figure in excess of $100 million.

This is where the smoke and mirrors come in. In the example above Hanover would effectively have written out a cheque to the borrower for $1.5 million and the borrower would then pay the $1.5 million back to Hanover as interest.

Hanover included this as interest received and, as a result, was able to give the impression that its earnings and operating cash flow were far stronger than they actually were from a cash income point of view.

This approach, while not inconsistent with accounting rules, is misleading.

How many individuals would have invested in Hanover if they realised that the interest due from property developers was deferred until these developers refinanced their loans with another financial institution or sold the properties?

These accounting policies allowed Hanover Finance to report higher profits than they would under more conservative accounting policies. It also allowed the company to boost its shareholders' equity, capital adequacy ratio and enhanced its ability to pay large dividends.

Hanover claimed this week that these massive dividends were only declared after "consideration by the board and management of a detailed 12-month rolling liquidity forecast". These forecasts must have been unbelievably optimistic as Hanover paid a $28 million dividend in the July-December 2007 period as its cash resources plunged from $149.7 million to $80.2 million, and a $17.5 million dividend in the January-June 2008 period as its cash dwindled from

$80.2 million to just $36.9 million (most of these cash resources have now been depleted).

How could Hanover Finance pay these huge dividends when only 7 per cent of its loans were paying interest, property development sales had stalled and its cash resources were depleting rapidly?

But the biggest issue is the large number of commercial arrangements between Hanover Finance and other companies owned by Mark Hotchin and Eric Watson. These are called related party transactions.

These related party transactions were one of the biggest problems during the 1980s sharemarket boom and bust. Controlling shareholders bought and sold assets and initiated other commercial transactions between them and the listed entity.

The controlling shareholders consistently claimed that these transactions would benefit minority shareholders. However, after the October 1987 sharemarket crash investors quickly realised that minority shareholders had been duped, most of the related party transactions were totally one-sided with the controlling shareholders being the clear winner most of the time.

As a consequence the NZX introduced strict related party rules, with all transactions that exceeded 5 per cent of a company's sharemarket capitalisation requiring minority shareholder approval.

These rules would capture almost all of Hanover's related party transactions but the company is not listed on the NZX.

Hotchin made a number of comments about improved corporate governance when Greg Muir was appointed chairman of Hanover in December 2005. He said that Hanover was going to set new standards in this area and raise the bar for New Zealand finance companies. Muir mustn't have been paying attention because it is difficult to detect any improvement in governance since he became chairman.

For example, why did Hanover lend $8.6 million, on a capitalised interest basis, to a Hotchin and Watson company on July 10, just 13 days before it announced a moratorium? This loan was used to purchase 54 lots at the troubled Jack's Point development.

Surely this money, which ranks behind a first ranking mortgage of $5.7 million held by another financier, would have been better utilised on an interest-paying loan?

The ironic aspect of the debt restructuring proposal is that it involves the biggest related party transaction of all, namely the purchase of the Axis property companies from Hotchin and Watson. Hanover is acquiring the assets and liabilities of these companies, which mainly consist of development sites at Jack's Point, Clearwater Resorts and Matarangi Beach, for $40 million. The $40 million payment will be made only if and when all of Hanover Finance's

secured debenture holders have been repaid.

Very little information has been provided on the Axis companies but PricewaterhouseCoopers concludes that there is no equity in the Jack's Point project and Hanover is unlikely to get all of its $34.8 million loans back. If the Jack's Point companies go into receivership then Hanover, the new owners, will carry the can instead of Hotchin and Watson.

Matarangi Beach Estates has the following financial structure:

* First mortgage to a registered bank of $21.7 million.
* Second mortgage of $26 million to be acquired by Hanover from Hotchin and Watson.
* Third mortgage of $12.6 million held by Hanover.

Thus the company has total debt of $60.3 million and apparently no income except through the sale of sections.

The important point is how many sections it can sell and how long it takes to sell them.

The total cost of running Matarangi Beach is probably around $3.5 million a year, including interest on the bank loan, rates, etc.

As the average advertised price of sections at present is $220,000 then it will need to sell 16 sections per annum just to cover its running costs yet Quotable Value records only seven section sales in the past 12 months.

As a ball park figure Matarangi Beach Estates will probably have to sell around 150 sections by December 2013, or 30 sections a year, for Hanover to get any of its second mortgage back.

In other words $66 million of the proposed $96 million to be injected into the proposed restructuring by Hotchin and Watson will be virtually worthless unless these 150 Matarangi Beach sections are sold. The $66 million comprises the $26 million second mortgage at Matarangi Beach and the $40 million equity in Axis.

The complexity of these arrangements and the lack of detail on the Axis group of companies make it difficult to assess the debt restructuring proposal, particularly as Hotchin and Watson are transferring many of their property liabilities to Hanover.

The only definite conclusion one can draw from the Hanover debacle is that there will be very little confidence in the finance company sector until related party transactions are regulated and far better corporate governance and accounting standards are introduced.

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.