Banks only winners in Babcock crash

The directors of Babcock & Brown effectively flicked the switch on a firewall strategy that ring-fenced its assets from creditors as it lurched towards insolvency late last year.

The move ensured the group's syndicate of banks ended up with complete control over the disposal of its assets in order to recover $3.3 billion of loans.

It also led to the almost total separation of B&B from its main subsidiary that owned the businesses.

Consequently, B&B's creditors, who include noteholders owed $600 million, have found themselves virtually powerless in any attempt by the company's liquidators, Deloitte, to regain control of the assets. In doing so, they will lose almost all of their money.

The firewall plan was activated five months before administrators were appointed to take over the running of the asset management and investment group, which was valued at $12 billion at its sharemarket height but is now basically worthless.

It has since become evident that the firewall had its genesis in the issue of the very same debt securities that the noteholders now know to be worth nothing.

While that may not have been the original intention of B&B's chief executive, Phil Green, who first proposed such a fund-raising move to his fellow directors in late 2004, the terms of three separate issues of subordinated notes basically left their holders with almost no recourse to the company in the event of its collapse.

Those investors thought they were putting their money into B&B Limited. But what happened is that B&B lent their money to its operating subsidiary, B&B International Pty Ltd (BBIPL) to continue expanding the business  ironically by raising more debt  without the investors getting any hard security in return.

Such detail didn't seem to matter in the boom days between 2005 and 2007 when B&B was delivering huge profits and its shares shot up from their issue price of $5 to $34.

However, when the bust arrived and its stock collapsed in value, specialist investors such as the noteholders, who thought they were in a better position than shareholders, found themselves behind the bankers, who had first rights over the group's assets.

But those assets weren't to be found in B&B. It was only a holding company and while it owned 99 per cent of BBIPL, it, too, had only shareholder rights, which have turned out to be of limited value when there is a huge amount of debt to be repaid.

That is exactly the situation that faced the noteholders this year when B&B's plight threatened their investments.

Unable to meet the regular interest payments on the notes or any demand to repay the original money, B&B offered to buy the investors out at a token sum that equated to an almost total loss.

Refusal to accept the offer would result in B&B being placed in administration, the board warned. The noteholders opted to stare down such a threat and chose what they thought might be the better option of recovering more money from an administrator.

B&B duly threw in the towel on the day of the result of the first noteholder vote: March 13. The one-time sharemarket darling was no more.

To really understand what happened to B&B, investors have to go back to June last year when the global financial crisis finally caught up with the group.

Midway through that month, no less a figure than B&B's founder and executive chairman, Jim Babcock, asked his fellow directors to consider the group's solvency in light of the squeeze on its finances.

It was a pivotal moment for the company. Until then  and publicly at least  B&B had expressed confidence in the way it was coping with the fall-out from the global financial crisis even to the extent of sticking by its forecast of yet another record profit for the year to come.

Behind the scenes, though, the situation was markedly different. As a result of Jim Babcock's caution, the board initiated what became known as Project Veyron, which was designed to pull in a big equity investor at the same time as restructuring the group's business.

Of equal  and eventually more telling  importance was that a continuing fall in B&B's market capitalisation had triggered a breach in the banking covenants that its main operating business, BBIPL, had with its main lenders.

The debt built up over the four years since B&B listed was beginning to squeeze the life out of the group. And such was the speed and impact of the GFC on the company that both Jim Babcock and Phil Green were gone from their executive jobs even before the seminal collapse of Lehman Brothers in September.

If June was a turning point, then August was a major reversal: the profit forecast was ditched and replaced with a warning of lower earnings; Green and Babcock took the blame and resigned but sought to maintain links with the company they built by staying on as non-executive directors.

At the same time, though, the board contemplated the previously unthinkable: the sale of the whole business and expanded Project Veyron to sound out possible buyers.

The debt problems being encountered by its listed satellites were also catching up with B&B, most notably Babcock & Brown Power.

The group agreed to vary the terms of a $400 million loan owed by BBP to the mothership to ensure the power fund could continue.

It appeared to the board that as soon as one issue was dealt with, two more were just around the corner. But nobody could predict the impact of the decision the following month to let Lehman go to the wall.

The demise of the once powerful investment bank  an institution by which B&B judged its own pay and reward schemes  set in train the events which subsequently led to the group's own failure.

With confidence in debt-fuelled and asset-churning operators such as B&B collapsing, the board could only watch as its share price plummeted.

Reeling from the strain of the past few months and unable to adjust to a non-executive role, Green quit the board and sold his B&B shares in mid-October. Jim Babcock followed him at the beginning of November but remained a significant shareholder until the bitter end.

The events of November brought matters to a head. According to Deloitte, B&B was almost certainly insolvent by the end of that month  3 months before it was officially declared to be so.

It was also when B&B and BBIPL  who shared identical boards of directors  went their separate ways as the banks increased their pressure on the main subsidiary to restructure its debt and define a clear path as to how it would realise its assets to pay them back.

This lies at the centre of the claim by the administrators that the board was inherently conflicted: between its role in running B&B and being responsible to its creditors and protecting the longer-term interests of the group, primarily through BBIPL.

B&B depended on the money that flowed to it from BBIPL. Without it, the ASX-listed company had no future.

But the board's priority now appeared to be the solvency of BBIPL. Understandably, the mood in the boardroom was by now sombre.

After an exhaustive discussion, the remaining directors  Elizabeth Nosworthy, who had replaced Jim Babcock as chairman; new deputy chairman Pat Handley; independent non-executive Ian Martin; and Green's successor as chief executive, Michael Larkin  concluded BBIPL could remain afloat if its main lending facility was restructured.

That resulted in an announcement to the ASX in February that indicated B&B could survive through a pay if you can deal to hand back $2.1 billion to the banks by selling assets over a three-year period in what was a winding-down of the group by its own management.

However, the main beneficiary of the deal was BBIPL, not B&B. A trawl by Deloitte through the board minutes of both companies during November showed no evidence that B&B was to be accommodated in the new debt deal.

The group's management has told the administrators that B&B may have survived if the first of two proposals  known as Plan A and Plan B  put to BBIPL's banking syndicate in December had been accepted.

Plan A envisaged a recapitalisation of the group  seemingly through an equity injection by the British private equity firm Terra Firma  while Plan B called for the sale of all of its assets. The banks, as everyone now knows, opted for the latter and Deloitte says the board minutes do not reflect that the position of B&B was ever separately considered at the time.

The introduction of the firewall strategy (separating B&B from BBIPL and the rest of the operating companies) in November suggests that BBL may not have had the group's continued financial support from that time onward, said the administrators in their report to creditors.

Two other factors had a critical bearing on the discussions held by the directors over that period.

One was the offer by Terra Firma to buy 91 per cent of BBIPL for $2.5 billion (a deal that would help repay the bankers but leave virtually nothing for the quoted company's shareholders and creditors); the second a decision by the group's long-standing banker and original shareholder, HypoVereinsbank, to hold onto a ?72 million cash deposit, given the real prospect that the group was going under.

HVB's move started a domino effect. Confidence among the group's counterparties collapsed, prompting Terra Firma to withdraw its offer. The board also commissioned a financial report from KPMG that highlighted an impending short-term cashflow crisis.

It was this that caused BBIPL to approach its bankers for emergency funding and which led to the renegotiation of its main corporate borrowing facility on tougher terms.

The result saw B&B effectively cut off or divorced from the rest of the group with responsibility for corporate governance shifted to BBIPL, Deloitte says.

We do not believe that the position of B&B Limited was adequately addressed or that adequate steps were taken to protect [the company] from conflicts of interest between it and BBIPL, it said.

Identical boards continued to control both entities and no steps were taken to appoint committees to oversee the management of the obvious conflicts of interest.

The role of the two boards and the directors' decisions over that period are just two issues that Deloitte believes deserve further investigation if creditors and litigation funders choose to fund such inquiries.

Meanwhile, B&B is being wound up after being placed into liquidation last month. Estimates of its last accounts show B&B incurred a $2.56 billion impairment charge for the 15 months to March 13 this year resulting in a loss of $2.46 billion.

Its liabilities stood at $633 million, primarily owed to its noteholders, and it had just $1.4 million in cash. As for the chances of the liquidators recovering more than a few million dollars, those are very slim indeed.

And what of BBIPL? From an accounting perspective, its position is worse. Figures for its year ending December 31, 2008, show a loss of $5.6 billion after racking up impairment charges of $4.9 billion. Its assets of $12.4 billion were overwhelmed by total liabilities of $14.59 billion, leaving it with net liabilities of $2.1 billion.

By any other calculation, it would be facing the same fate as its former parent. But BBIPL remains a going concern because it has the support of its bankers, who also have the final say over what happens to it.

To that end, a small management team under Michael Larkin's control have been directed to sell off all of its infrastructure, transportation, energy and real estate related-assets.

It is receivership in all but name. Meanwhile, nobody expects the banks to come out of the B&B saga without a large haircut.

But it won't be at the same high price, in percentage terms at least, as that paid by the group's shareholders and creditors who joined what turned out to be rollercoaster ride and got taken for one instead.

THE UPS

1977 Formed in San Francisco by James Babcock and George Brown.

1982 Sydney office opened.

1984 Phil Green comes on board.

1986 Starts aircraft leasing business.

1989 Enters the real estate market from which it establishes operations

in Japan and Europe.

1997 Takes control of Australian Industry Development Corporation from which it starts to build its infrastructure operations.

2003 Moves its corporate headquarters and main area of operations to Sydney.

2004 Listed on the ASX at $5 a share.

2005 Secures a corporate debt facility of up to $820m; Issues first series of public debt securities (B&B notes) for $266.

Shares finish the year at $18, having touched nearly $22.

2006 Increases corporate debt facility to $1b and then again to $1.32b;

makes full year net profit of $252m; issues second series of notes to

investors raising NZ$225m and follows that with a third issue worth A$150m.

Shares close out the year at $26.

2007 Declares full year net profit of $407m and increases corporate debt

facility to $2.35b. Buys energy group Alinta. Bull market sends shares in March to highest level at just over $34, valuing B&B at $12b. But impact of the GFC and concerns about its debt level starts share price slide.

Shares ends the year almost 50% down at just under $18.

2008

February Declares full year net profit of $643m; forecasts 2008 profit of $750m.

March Increases corporate debt facility to $2.8b.

Shares under $15.

May Re-affirms annual profit guidance at Annual General Meeting.

Shares fall below $10.

June Board looks for equity investor to shore up company. Jim Babcock asks directors to consider groups solvency. Declining market capitalisation triggers

breach in debt covenants.

Shares down to $5.

August 11 Announces 25%-40% likely cut in interim profit and says annual

earnings to be no more than the previous full year figure of $643m.

Shares down to $2.

August 21 Phil Green quits as CEO and is replaced by finance director Michael Larkin, Jim Babcock stands down as chairman. Updates market about plan to shrink the companys operations.

Listed satellite funds accelerate moves to split from parent group.

September Ratings agency S&P cuts credit rating on $3b of debt held by main

subsidiary, B&B International Pty Ltd (BBIPL). Phil Green resigns as a director

and sells his remaining shares.

Share price hits 76 cents.

October British private equity company Terra Firma emerges as lead bidder for

equity stake in B&B.

November B&B announces it will focus on infrastructure. Jim Babcock quits the

board. Terra Firma lodges $2.5b to buy 91% of BBIPL. HypoVerinsbank, holds onto

?72m deposit that prompts withdrawal of Terra Firmas offer.

December Secures short term lending support of $150m.

2009

January BBIPLs banking syndicate will keep it afloat to allow it to sell assets.

February B&B makes offer to holders of its debt securities to buy them out.

March 13 Noteholders reject offer; Faced with insolvency, B&B directors, led by

chairman Elizabeth Nosworthy, call in Deloitte as administrators.

Shares suspended at 32.5 cents.

April 29 Remaining directors including Ms Nosworthy and Michael Larkin resign.

May Nosworthy and Pat Handley quit the board of BBIPL, leaving Larkin as CEO.

June B&Bs shares de-listed from the ASX.

August Creditors vote for liquidation

THE BABY BABCOCKS: Where are the ASX-listed satellites now?

Babcock&Brown Power

Main assets: Gas and coal-fired power stations.

Future in the hands of its bankers.

Owes lenders $2.6 billion and $400 million to its former parent, B&B.

Seeking to restructure its debt.

Taken management in-house, planning name change. Net loss last year $149 million.

Share price: 6.3 cents.

Babcock&Brown Infrastructure

Main assets: Ports, coal terminal, energy distribution. Future dependent on its bankers. Desperately needs equity injection. Owes $10 billion. Separated from B&B and BBIPL. Taken management in-house, changing name to Prime Infrastructure.

Net loss last year: $977 million. Share price: 5.3 cents.

Infigen Energy

Main assets: Wind farms. Future secure. Changed name from B&B Wind Partners.

Completely separated from B&B and BBIPL. Management taken in-house. Selling assets in US and Europe to concentrate on Australia. Few debt issues.

Net profit last year: $193 million.

Share price: $1.37.

Eircom Holdings

Major asset: 57 per cent stake in Irelands main telecoms company.

Set to be taken over. Changed name from B&B Capital. Separated from B&B and BBIPL. Management taken in-house. Now returning capital to

investors. Subject of agreed bid from ST Telemedia. Loss last year: $1.4 billion.

Share price: 51.5 cents (after 80c return last week).

Babcock&Brown Residential Land Partners

Main assets: Residential land and property developments. Chances are it will survive.

Changing name to RCL Group. Separating from BBIPL, management taken in-house.

Needs to restructure its $100 million debt facility. Renegotiating $21.5 million loan

from BBIPL.

Net loss last year: $26.6 million.

Share price: 9.6 cents.

Lend Lease Prime Life Trust

Main assets: Retirement home and aged-care village operator. Future secure.

Recapitalised in January by new major shareholder Lend Lease. Changed name from Babcock & Brown Communities. No further links to B&B or BBIPL.

Net debt cut by: $143 million to

$423 million.

Net loss last year: $247 million.

Share price: 22 cents.

Astro Japan Property Trust

Main assets: Offices, shops and properties in Japan. Should survive reasonably well.

Changed name from Babcock & Brown Japan Property Trust. Due to complete separation from BBIPL in March.

All corporate debt repaid; looking to refinance $183 million of debt by March.

Net loss last year: $366 million

Share price: 44 cents.