What happened at Westpoint?

The Westpoint group of companies was in the business of erecting large-scale residential buildings in the central business districts of Australia between early 2000 and late 2005. It was constantly hungry for cash.

The group had little or no capital and lived on borrowed funds. Those who controlled Westpoint knew two things for certain: if they made full disclosure as to the financial position and the business systems of Westpoint then they would raise little or no funds for their developments; and their best chance of raising funds in these circumstances was to separate the investment decision from the ownership of the investment funds.

Westpoint could overcome the problem of disclosure by obfuscation; they overcame the second problem by locating a small number of financial planners who, for a price, were prepared to close their eyes to the obvious. That Westpoint carried on business in this manner over such a long period should be a matter of concern to us all.

In every free-enterprise system some enterprises will fail despite the best efforts, honesty and endeavour of those who control them. Some fail because they become victims of the business cycle, because of some catastrophic and unforeseen event or because of the hubris of long-term management.

Westpoint was not such an enterprise. The companies failed because: they were not particularly good at what they did; theirs was a business that almost demanded explosive growth; their business was based upon the most expensive form of funding (high commission rates and high interest rates); and their business was driven by basically dishonest senior management.

Westpoint’s “mezzanine” schemes

Westpoint set up a number of $2 shelf companies which they, rather mysteriously, referred to as “mezzanine companies”. This made no difference to their status: they remained $2 shelf companies. Each shelf company was insolvent from the moment of its incorporation.

In a typical transaction the insolvent $2 shelf company then went into the financial planning market and announced it was raising, say, $50 million by way of promissory notes to fund the development, by another Westpoint company, of a nominated CBD building.

The “development company” was also specifically incorporated for the purpose of undertaking the development in question. If any particular development failed then, in theory at least, only the “mezzanine” and the “development” company went down, leaving the balance of the Westpoint empire to carry on regardless.

This was the avowed aim of Westpoint management in setting up this structure '” so that as and when a development failed it would not pull down the whole Westpoint structure.

Working with the financial planning industry had several advantages: it was obvious that some planners would close their eyes for a price; and that those who were prepared to do so already represented, and had the trust of, large numbers of small-scale individual investors. Westpoint would not have to persuade each independent investor to put money into its promissory note schemes.

The downside was that Westpoint would have to pay dearly for this privileged access to investors.

Historically, finance brokers have been paid fees of 2–3% on funds advanced by their clients. There is no real difference between the role played by finance brokers and that of financial planners in the Westpoint schemes. Planners should therefore have expected fees of 2–3% when they advised their clients to take up the Westpoint promissory notes. To access this pool of funds, Westpoint was prepared to pay two, three '” even four '” times the normal commission.

The $2 shelf companies could not raise these funds by issuing shares because that would have meant producing and delivering prospectuses to each potential investor. If they issued convertible notes or debentures they would have to appoint trustees to represent the investors.

Someone at Westpoint or some adviser of Westpoint hit on the idea of issuing promissory notes with a face value in excess of $50,000. The Corporations Act excludes from the definition of debenture a promissory note in excess of that amount. If the promissory note in excess of $50,000 was not a debenture then it was not a security and the protective provisions of the Corporations Act in relation to securities would not apply.

So the $2 shelf company adopted the following procedure: it delivered an “information” memorandum to the financial planner; the planner recommended that the client make a loan of more than $50,000 to the $2 shelf company; the $2 shelf company issued a promissory note (an IOU) to the client and undertook to repay the loan on a particular date in the future and in the meantime to pay around 12% interest per annum; and the $2 shelf company paid the financial planner its commission.

This procedure meant, of course, that the client was unsecured '” lending funds to an insolvent $2 company without security. The information memorandum made it clear that the $2 shelf company would pool the funds and advance them to the development company for the purpose of that development company developing a CBD property.

The development company would provide a second-ranking mortgage over the development property to the $2 shelf company and would also provide a second-ranking charge over its assets and undertaking to that company. Any security actually provided would therefore be held by the $2 shelf company not by the investors. In addition, a guarantee would be provided by various Westpoint companies but, again, that guarantee would be given to the $2 shelf company not to the investor.

In theory the development company would pay monthly interest on the amount borrowed from the $2 shelf company. Where this would come from is a mystery, given the development company was itself a shelf company. The development company would borrow other funds from mainstream banks and lending institutions, erect and sell the building then repay the $2 shelf company from any profits.

In fact each $2 shelf company was insolvent from its inception. They were incorporated specifically to gather investors’ funds and (in theory) on-lend them to the development company. They paid interest at 12% from the time they received the money, but until it was passed on, they received no income but for 4–5% bank interest. Even if their overheads were covered from elsewhere in the group, the shelf companies were insolvent from the outset.

None of the information memorandums actually set out the financial position of the borrower company '” no accounts were ever provided that gave even the merest clue to the financial status of the borrower. In the absence of such information it is a matter of first principle that those advising the investors should have looked to the worth of the guarantees. Knowing the borrower was a $2 shelf company it followed that the real chance of repayment was through the guarantee.

It is difficult therefore to imagine how any financial planner could have recommended this investment (in the absence of any knowledge as to even the identity of the guarantor let alone the financial standing of the guarantor). If an information memorandum is silent on the financial position of the borrower or the guarantor for an unsecured loan, any financial planner who recommends the loan and collects an abnormal commission would be very brave indeed to stand before a court and say the commission did not affect his recommendation.

The offer, in plain speak

In plain English, planners should have told potential investors: “I have come across this investment. These guys from Western Australia have set up a $2 company that has no assets and no track record in property development. The idea is that you lend your money to the company. You don’t get any security but they will give you an IOU. Your investment will be pooled with those of others and lent to another $2 company in the same group which, we hope, will use it to develop a property in the CBD.

“This structure means you will be investing in what is called a managed investment scheme. This particular scheme is unlawful in as much as it is not registered and the $2 shelf company is not licensed as a responsible entity. Because the company is not licensed it is highly probable it is not insured. You will have no control whatsoever over the investment and no promises have been made about keeping you informed as the development proceeds.

“If the promoters of this $2 company cannot find the money to pay your interest or to repay you when the loan falls due then you will be able to sue company (which will not be much use) or you will be able to sue other Westpoint companies who are providing a guarantee. I can’t tell you whether the guarantees are any good because I don’t know anything about the financial position of these guarantee companies. In fact I don’t even know which Westpoint companies are supposed to give the guarantees.

“The promoters have pointed out that you do not have the normal protection under the Corporations Act that is given to large-scale investments. I am getting three times the amount I normally get for putting you into this investment but that isn’t the reason I am doing so. It is a lucky circumstance that I think this is the best possible investment for your money while at the same time giving me the best possible result. By the way, I am not insured and the company which is actually giving you the advice has no assets.”

Such truthful advice would not have raised any funds at all for Westpoint and would have earnt no commission for the truthful adviser. This is because it sets out all of the risks which would face the investor.

The voracious animal

Over the years many Australian entrepreneurs have created voracious corporate animals. At Rothwells, Laurie Connell kept doing one bad deal after another hoping that, eventually, one would take him out of all his problems. Instead of that his voracious animal got bigger and bigger and he had to do bigger and bigger deals and take bigger and bigger risks to keep feeding it.

Norm Carey and Richard Beck did exactly the same thing. They created a voracious animal that kept eating all of the commissions and all of the 12% interest rates. It had voracious overheads so that every minute of every day money was going out the door and the only money coming in (if any) would be the profits on large-scale property developments that had to be completed and sold on budget and on time.

As each budget blew out and each deadline came and went without fulfilment the animal got bigger until it was out of control. New strategies had to be created to prevent this animal from being seen for what it was, hence the “roll over” of the promissory notes. As the due day for payment arrived and the Westpoint group companies were unable to pay on their promises the notes were rolled over to alternative promissory note schemes.

In the circumstances of this case, “roll over” was a euphemism for “can’t pay” '” it was a euphemism used to put off the eventual admission that the animal had grown so large it could no longer be fed.

The rollovers

Each promissory note promised to pay a nominated amount on a nominated date. Because the loans referred to in the promissory notes were unsecured, repayment on time was absolutely essential. If a loan is fully secured then timely payment is not so necessary because eventual payment is certain. Failure to pay an unsecured loan on time is the initial danger signal for what is becoming a pear-shaped investment.

Obviously it would be easier for Westpoint to go back to investors through the financial planner and have the planner persuade the investor that his or her investment should be “rolled over” into a promissory note in an alternative Westpoint development. Administrators appointed to some of the $2 shelf companies have since reported that Westpoint paid planners commissions of up to 8% in return for their clients rolling over into alternative promissory note schemes.

To the extent this occurred it added insult to injury '” not only did the investor not get repaid but his adviser received a commission of 8% of the amount he did not get repaid. This is a good example of Westpoint’s “ruthless disregard” of investors referred to by Justice French in ASIC, Richstar Enterprises Pty Ltd v Carey.

A moment’s reflection by the financial planners (or by ASIC, for that matter) upon these roll overs would have revealed the following: the investors held promissory notes in development A; development A could not afford to repay the promissory notes; development B was then set up and new promissory notes were issued to the investor in redemption of the promissory notes from development A; the legal result of all this was that development A no longer owed the investor, development B now owed the investor and development A owed development B the amount of the promissory note; development B began with an asset that was a debt from development A which could not be paid; and the promissory note from B to the investor had little or no value.

The point was probably reached whereby Westpoint deliberately started new “developments” solely to enable it to issue promissory notes in those developments in exchange for promissory notes in earlier developments that they could not afford to pay.

With developments proceeding at the pace adopted by Westpoint, the regulator should have known that any indication of a failure to pay promissory notes when they fell due, especially if the amount in question was only a few hundred thousand dollars, was a clear indication of further trouble to come. ASIC has not yet said publicly when it first knew that investors could not get their funds out of Westpoint; that is, when it first knew Westpoint was defaulting on unsecured loans.

It is clear that Westpoint adopted the usual approach of the charlatan in this area by paying out the loudest complaints in return for confidentiality agreements whereby the complainants promised not to further publicise the Westpoint default.

The denouement

Judgment day came for Westpoint in late 2005 when ASIC moved to have receivers appointed to some of the $2 shelf companies. The shortfall has been variously reported as between $300 million and $450 million but the certainty is that it will be in the hundreds of millions of dollars. The claim put forward by Carey and Beck that, had ASIC done nothing, everything would have been OK is based upon the forlorn belief that “one day” everything would have been all right, sufficient profit would eventually have been made on the sale of the buildings to offset all of the monies owed to investors.

This argument drops away in the face of a finding like that of Justice Antony Siopis in the Federal Court that there was a good arguable case of unlawful conduct against Westpoint management (not just bad business practices and broken promises but unlawful
conduct).

Once all of the Westpoint companies were pushed over by ASIC, each investor had to face the bleak prospect of attempting to recover lost funds from an unsecured position. Some money, perhaps 15–20% of the investors’ funds, will be returned from the sale of assets. In the main, however, investors will have to fend for themselves; many will lose their entire investment and very few will be able to afford individual legal proceedings.

A financial collapse is like a car crash: for a time the victims cannot believe they have really been involved, it is something that always happens to other people. And, as with a car crash, the injury suffered prevents victims from being able to rehabilitate themselves; in this case, the funds they might otherwise use to pursue their loss have gone.

Surprisingly, some business commentators have referred to investors in Westpoint as being greedy because of the interest rate that was paid on their investment. The average investor in Westpoint was, in fact, an elderly retiree who had worked all his life in a business that he had come to know well and understood without the assistance of others.

That retiree had then come into a lump sum of a size beyond his experience. Prudence required that he invest the sum either as part of his superannuation or to produce income into his retirement. Because investment was beyond his normal experience, he sought advice from an expert licensed by the Government. No one should be judged a greedy, ignorant fool for seeking specialist, licensed financial advice before making an investment and then accepting that advice rather then second-guessing the specialist.

The great majority of investors in Westpoint promissory notes made their investment upon the advice of a licensed financial planner.

So what did ASIC do?

During the course of 2002 ASIC officers were advised of the existence of the so-called promissory note schemes and of the concern of some investors that they could not recover their funds. Several meetings were held between consumer advocates and ASIC officers during 2002 and thereafter. It also appears that in 2002 the Minister for Consumer Affairs in Western Australia warned ASIC about these schemes.

In early 2004, ASIC issued proceedings in the Supreme Court of Western Australia and requested that the court make a declaration that the promissory notes were either securities or formed part of a managed investment scheme. ASIC did not ask the court to impose an interim injunction on Westpoint to prevent any further promissory notes from being issued or rolled over.

In court terms the matter was dealt with fairly quickly and a judgment was delivered in November 2004. By that judgment, Justice Ralph Simmonds found that the promissory notes were not securities but did constitute a managed investment scheme.

ASIC did not ask the court to declare that, if the promissory note scheme in that case was a managed investment scheme, then it had to be registered under the Corporations Act. ASIC did not lead any evidence on this question one way or the other. As a result Justice Simmonds said he would not make a decision one way or the other on whether the managed investment scheme in that case had to be registered.

Even after getting this judgment ASIC did not apply to the court to wind up the managed investment schemes or prevent the creation of any further schemes. Instead, it embarked on a long-term effort to show that the mezzanine companies were insolvent and that receivers should be appointed over their assets.

ASIC did not apply for any interim protective orders based upon the ruling that promissory notes constituted a managed investment scheme. The $2 shelf company appealed in that case against the finding that it was running a managed investment scheme and ASIC appealed against the finding that the promissory notes did not constitute securities. Meanwhile Westpoint carried on business.

The result

All or most of the Westpoint companies are now under some form of external administration. The administrators are moving to sell the property developments for the best price available. Some returns will be made to those lucky enough to have invested in a scheme where most or all of their funds were actually used in the development.

Each $2 shelf company is hopelessly insolvent (and always has been) and so there is no chance of recovery from that quarter. The directors may be worth $15–20 million between them so that no substantial recovery is likely. The reality is that the financial planners who breached section 52 of the Trade Practices Act, various provisions of the Corporations Act and their duty of care to their clients are the only real defendants of substance.

Independent actions by each investor are out of the question '” 3000 or so individual writs against a multitude of financial planners would be an expensive quagmire for investors, planners and the courts. The only manageable alternative is a series of representative actions against individual planners who gave advice to large numbers of investors causing large-scale losses and who have either their own funds or sufficient insurance.

The future

Determining what should happen in the future means first outlining what happened in the past. There is little or no doubt ASIC could have brought down the Westpoint promissory note schemes by application under the Corporations Act to wind each of them up on the grounds that they were unregistered.

It was not necessary (despite the protestations of ASIC to the contrary) that ASIC establish the insolvency of the Westpoint operations. If a managed investment scheme is not registered when it is required to be registered then those who control it are breaking the law and nothing more is required.

In particular, it is no answer for ASIC to say it did not take winding-up action because to have done so would have caused unnecessary financial pain and embarrassment to Westpoint if in fact it was a solvent operation. It is no part of the law that persons can act in breach of the law so long as they do not cause loss or damage to others. If the promissory notes were issued in an unlawful manner that is the end of it. Those tasked with enforcing the Corporations Act should have done so at the earliest opportunity.

ASIC’s role in finally bringing Westpoint down is a highly commendable one; it is ASIC after all that applied for the appointment for the various receivers and who carried out all the investigations which finally showed just how rotten the Westpoint empire was. On the other hand, it is completely wrong for ASIC to have then mounted a virulent campaign to suggest that they could not have done anything more than they actually did to protect investors.

In circumstances where the compensation legislation had not been implemented and in circumstances where ASIC knew that there was no requirement for professional indemnity insurance and that the various $2 shelf companies were not themselves insured it should have acted to wind up these schemes from 2002 onwards.

Once the Westpoint group went into receivership and administration, ASIC began to inform the public that it could have done no more because it lacked jurisdiction. This was a campaign doomed to failure. It has now been condemned by Treasurer Peter Costello, who recently reminded ASIC of its managed investment powers.

Someone else’s problem

To a degree the Westpoint debacle can be seen as a direct result of our corporate culture. Our business habit is to live and let live. If we see some wrongdoing in our capacity as an adviser, business person, company director, banker or the like we are unlikely to report it or do anything else about it.

The culture is, in part, driven by the proposition that there is nothing in it for the observer of wrongdoing to take any action. It is often the case that, even where some action is taken and the matter is referred to the regulator, nothing comes of the referral. Certainly we are not encouraged to be proactive in preventing wrongdoing in our business community.

The approach is more likely to be that it is someone else’s problem. Many hundreds of business people must have known that there was something rotten in the Westpoint empire. Westpoint management, employees, advisers, financial planners and other business people must have known from at least 2002 onwards that something was seriously amiss.

Some actually did something about it; they did all that could do: they reported their concerns to the regulator. Where the regulator has all the power then the regulator must take all the responsibility. There is no doubt that, because of this indifference, we are destined to relive the history of our corporate disasters.

* Hugh McLernon is executive director of IMF (Australia) Ltd, which is funding a class action against financial planners over the Westpoint collapse.