In the five years before the government’s guarantee scheme started in 2008, Allan Hubbard’s company had turned itself into a quasi-Ponzi scheme. He had lent a billion dollars to people who were unlikely to repay it, and was having to borrow from new investors to repay earlier investors.
If a company lends someone’s money for an indefinite period, with no collection of principal, then the only way of repaying the investor is to use other people’s money. Therein lies the conundrum facing every finance company that aspires to offer loans on new property development projects. No project receives money until the project is sold, and the sale of individual titles produces cash. Then, and only then, will the developer have money to repay the financier, in turn enabling the financier to repay depositors. The situation is worse if the developer has no other income to service the loan. A loan to a developer at 18 per cent doubles every four years, thanks to compounding arithmetic. A development might take a decade to complete and sell. The borrower needs very deep pockets and many sources of income – or his finance company lenders will need very patient investors, or investors who have chosen very long terms, perhaps ten years for their deposits.
Between 2003 and 2008, South Canterbury Finance lent $1 billion to those who could not make regular loan reductions or, in many cases, any interest payments. If SCF had borrowed ten-year funds, interest compounding, it might have matched its lending to its borrowings. Its most obvious alternative was to put its faith in a high level of renewals and a constant flow of incoming money, hoping that the true mismatch it was creating would never be exposed. The fear of losing investor support explained Hubbard’s deference to Forsyth Barr, its largest ongoing supplier of money.
One finance company, St Laurence, did introduce a method of aligning funding with lending. In 2006 it launched its St Laurence Property Development Fund. St Laurence used shareholders’ capital to subordinate two million of its own money behind the $22 million it raised. This enabled it to lend $24 million and promise to pay investors 15 per cent if the lending was repaid. However, the parent company encountered troubles in early 2008, froze new lending in June of that year and then withdrew its prospectus for its debentures in September.1 In April 2010 the trustee, Perpetual Trust, appointed receivers. St Laurence founder and chief executive, Kevin Podmore, declared himself bankrupt in December 2011. Despite the subordinated capital, the investors in St Laurence’s Property Development Fund received back just a few cents in the dollar. Virtually none of the loans repaid anything. The lending standards were childish, including loans made to housing developments on flood-prone land in Brisbane.2
A better way would have been to offer a different product such as a property development managed fund, where the investors expected no particular repayment date and received no returns until the fund received money back from its development loans. To fairly match risk and return, such a fund would need to return all of the interest received, minus a management fee set at a low rate to reflect the fact that the manager had no risk other than to his reputation. Investors would then receive a return that was fairly matched to risk.
It is likely that none of the SCF directors or its lending executives ever contemplated this alternative. They would have had no reason to suspect that their quasi-Ponzi scheme was going to be uncovered by a drastic fall in market confidence. Worse, they may not have realised it had become similar to a Ponzi scheme. From SCF’s perspective, an impaired or bad loan became visible only when it could not be rolled over or when a project was obviously doomed. Because the trustee, the auditor, the regulators and the directors failed to uncover the extent of this dangerous lending, risk and subsequent bad debts were rarely mentioned. Sadly, even if SCF had used the managed fund structure, investors in the fund would still have lost much or all of their money. The SCF directors and lending executives proved unable to identify reliable developers and poor at administering property development loans.
SCF’s chief executive McLeod believed in 2007 that SCF did not do capitalised lending. He told me so. But Forsyth Barr’s 2009 information memorandum for its convertible note issue confirmed that ‘most’ of the $450 million owed by property developers was repayable only when their projects were finished.3 If McLeod didn’t know this, did the board know? Very obviously the regulators and trustees should have been told of this latent danger.
Some good decisions were made, however. In 2005 Hubbard made the excellent call to fund and take a majority stake in Face Finance (FF). This company, based in Christchurch, had been formed by two lenders, Warrick Baxter and Geoff Allott. Baxter, then in his thirties, had been well trained by ANZ and UDC Finance in the discipline of plant and equipment lending. He was experienced, hard-working, knowledgeable and well-connected. Allott, an ANZ graduate, was for a short while a well-performing New Zealand cricketer. Likeable, cheerful and modest, Allott and Baxter owned 25 per cent of Face Finance, while SCF owned 75 per cent.
The company skilfully expanded its instalment lending to contractors, transport operators and farmers, lending at low margins and attracting good-quality borrowers. FF was flexible with its most trusted borrowers as it developed its loan portfolio, enabling SCF to improve its loan diversification and to provide its trustee and its credit-rater with an impressive portfolio segment. Indeed, S & P rated nearly two-thirds of FF’s loans at AA level, making them eligible for securitisation – that is, on-selling loans at bank deposit-like rates to institutions such as the ACC or insurance companies or fund managers. Few of SCF’s other loans would have been suitable to on-sell to institutions. Hubbard was understandably proud of FF’s success.4 FF grew its book to a peak of nearly $300 million; it had minimal impairments, and was so profitable that its capital base grew to $15 million from retained earnings.
Hubbard made two other excellent decisions during this time. In 2005 both Marac and GE Finance had approached SCF with a view to purchasing the company, signing conditional term sheets, GE for $300 million, Marac for nearer $280 million.5 Both offers were subject to due diligence. Hubbard’s wily decision was to avoid any such inspection, and to prevent unwanted expert eyes exploring his official ledgers and the unofficial ledger cards which he had safely locked away. These were the real records of deals he did not want scrutinised.
Hubbard had also long hinted that he would list SCF, or perhaps Southbury. Having realised SCF would not survive due diligence, Hubbard could hardly have allowed Forsyth Barr to investigate an NZX listing for SCF in 2005. A stock exchange listing would have required multiple due diligence processes. Although 2005 was a year of exuberance, when the NZX was unimpressively managed, it was highly likely that SCF’s potential listing would not have survived expert scrutiny. The day before FB was to announce SCF’s listing in 2005, Hubbard unilaterally withdrew SCF from the process. He paid FB $1 million as a cancellation fee.
After cancelling the sale of SCF to a competitor, and shelving the alternative of the NZX listing, Hubbard later had the idea of using his influence at Dominion Finance (DF) to engineer a back-door listing by selling SCF to Dominion and then changing Dominion’s name back to SCF.6 This would have left the due diligence to Dominion Finance, an Auckland property finance company badly managed by Terry Butler, who would have gone to jail had he not died. Though Butler escaped his day of reckoning with the New Zealand judiciary, his fellow DF directors did not.7 In August 2013, Ann Butler (Terry Butler’s widow), Robert Whale, Richard Bettle, Paul Forsyth and Vance Arkinstall variously received sentences of home detention, community work and reparation payment orders after being convicted of criminal charges brought by the Securities Commission, while former DF chief executive Paul Cropp was jailed.
I had visited Butler at his request at his offices and boardroom on a main road in Parnell. While sitting uncomfortably listening to his codswallop, I gazed outside at a Mercedes Benz convertible sports car, wondering if this was the ‘office’ car. ‘See that?’ Butler asked. ‘I gave one of those to my son-in-law last weekend for his birthday present.’ Perhaps he had used this line before to someone who was impressed by it. Hubbard, however, described Butler as clever and from a good South Canterbury family, so he bought a few million Dominion shares, presumably to give him leverage for his idea of a back-door listing. My guess is that Butler would have given anything to link to SCF, which in 2007 had a respectable image beyond Dominion’s dreams. Butler would not have had even the foggiest idea of how to perform due diligence on SCF.
I became aware of this improbable idea in 2007 when Hubbard was in hospital fighting bowel cancer and then renal failure. I wrote to Hubbard exhorting him not to join forces with Dominion or Butler and warning him about Butler’s duplicity. One of the deals I cited was a loan to Rod Petricevic, the Bridgecorp founder who was later jailed. Another may have been Butler’s loan to an improbable proposed residential development at Baring Head, which faces Cook Strait on the bleak and rugged heads of Wellington harbour. For weeks after I wrote, Hubbard was uncharacteristically silent. I thought that I had offended him and that he had cut me off. Eventually he replied with a handwritten note saying that after reconsidering he had dropped the idea. Of course, in 2007 only a few people with access to his files, principally his bankers, had any insight into SCF’s decay. I did not.
Nor did many know of the confusion Hubbard was creating with two illegally managed entities, Aorangi Securities Ltd and Hubbard Management Funds. This behaviour marked a change from his approach prior to 2003. Hubbard had formed Aorangi Securities Ltd (ASL) in 1974 to collect surplus money from the clients of his accounting firm, Hubbard Churcher, and lend it to other clients of the firm on the basis of mortgage securities. The concept was sound. It sought to reduce the intermediation costs to both parties, borrowers and lenders, and to provide him with income by charging a fee to manage the transactions. It collected funds sometimes by using (illegally) an application form specifically restricted to lawyers, and it allowed people who loosely fitted the definition of the ‘friends, family and private clients’ to invest in ASL without issuing a registered prospectus and investment statement. One could argue that even the loose rules around contributory mortgage funds barely covered Aorangi, even in the days when it was well run. Later it looked to many like a finance company, which would have been expected to adhere to much more prescriptive rules.
The way ASL was formed and operated was fairly typical of Hubbard. As its chief executive he would argue vehemently that ASL was ‘kosher’, a word he often used. Other Hubbard Churcher partners were directors of ASL, including his partner Duncan Brand, a man most (including myself) would trust completely. His son-in-law Bob Linton, married to Christine Hubbard, was a loyal and diligent administrator, controlling the various papers, carefully recording transactions and running an accurate computerised deposit ledger. Between 1986 and 2003 ASL behaved like a contributory mortgage nominee company, collecting deposits and assigning to them a part or all of individual first mortgages, mostly over rural land. Interest was charged and usually paid. The investors received 10 per cent returns. When investors sought repayment they were repaid. If ASL had been formalised, it would have been a successful contributory mortgage nominee company, according to the man who for a short while was charged with untangling it, the statutory manager, Graeme McGlinn.8
From 2003, Hubbard occasionally exploited ASL’s lack of rules, using large sums of unallocated money to put with Southbury or SCF. The money raised by ASL clients was used for a wider range of purposes. At one stage in 2009 it had lent $40 million to Southbury Group, which in turn lent to SCF, and it was regularly lending to Hubbard’s charitable trust, Te Tua, which in turn would lend to struggling young farmers without charging interest. Hubbard would pay interest for those he was helping.9 In 2009 Brand discovered that Hubbard had siphoned off many millions of ASL client money to SCF through the Southbury Group. The discovery galvanised Brand. He challenged Hubbard, describing the use of ASL money as ‘unacceptable’.10 Hubbard argued that the money was just ‘parked up’, awaiting mortgage lending, but this proposition was absurd. If there were no lending opportunities the money should have been returned to investors.
Hubbard had three options. He could have arranged for the money to be repaid, though this may have been painful; he could have obtained investors’ agreement to merge ASL with SCF; or he could have injected his own money into ASL to offset the ‘park up’ in Southbury. The best solution was to merge ASL into SCF but by then the Crown was guaranteeing SCF depositors. It is highly likely it would not have agreed to increase its underwrite by $100 million. Others who tried this found themselves at odds with the law. Clearly neither Southbury nor SCF had the money to repay ASL. SCF was by then desperate to repay its American lenders. So Hubbard made what eventually proved to be the misunderstood but fateful decision to inject $42 million (nett) of his own assets. To underline his commitment to his ASL investors he subordinated his $42 million injection, meaning he could never be repaid until all other investors had been repaid.11
The intent of Hubbard’s transactions was entirely honourable. It strengthened ASL and removed any risk of a failure to repay investors. Of course, by mid-2009 Hubbard was under extreme pressure, trying to save SCF from what he was later to say were the ruins created by McLeod and Bosworth.12 Hubbard himself was making irrational decisions, none more obvious than his offer to clients to add his and his partners’ personal guarantees, without consulting his partners.
It was not until 2010 that the Companies Office investigated ASL. As I will explain later, the investigation misunderstood Hubbard’s transactions with ASL, using his input of funds as the reason for scuttling SCF’s hope of survival. I thought the Crown mistakes were egregious, and several notches below the standards I would expect. Yet Hubbard risked this sort of error-ridden outcome by his constant breach of approved practices and by his complex financial juggling.
Between 2003 and 2008 Hubbard had also expanded another illegal company, Hubbard Management Funds (HMF). Whereas ASL was for fixed interest investors, HMF was an equity fund managed solely by Hubbard, again without any external supervision or even any real record-keeping. The fund was to be for clients who trusted Hubbard’s reputation as a financial wizard. He received cheques in the mail, often with no wider brief than ‘to invest as you see fit’. The original intention was for Hubbard to manage individual portfolios. Later HMF behaved more like a managed fund, apportioning securities to individual portfolios once a year, in a random way.
HMF investors must have believed that Hubbard had special ability to pick winners in the sharemarket, perhaps because of his 50 per cent ownership of Munro Hubbard, a small Timaru sharebroking firm, later integrated into Forsyth Barr. The truth was that Hubbard had no genuine experience in managing share investments for others. He punted. Sometimes he won. Sometimes he lost. He could afford to play. He did make various conventional selections, like Ebos, and some smart choices, including a large holding in Xero, from its original listing. He also speculated in high-risk mining start-ups.
He invested in farms, unlisted businesses, sometimes in mainstream shares (like Ryman), sometimes in his own enterprises. He speculated in high-risk ventures. There is a chasm between investing and speculating, especially if other people’s money is being used. Those who manage money for others need to know each client’s appetite for risk, their ability to absorb losses, their financial objectives and the time they have to allow saplings to become trees. Such a manager needs to network with the best-informed and most important participants in equity markets and spend hours reading about and visiting targeted companies. Hubbard was an emotional, instinctive share investor, without the temperament for a funds management role or the time to perform the research. His network was limited. He had a close relationship with FB’s chairman, Eion Edgar, but his best selections came from his occasional discussions with First New Zealand Capital (FNZC), where Ralph Goodwin, an experienced wealth manager, helped him with conventional investments.
He also dealt with random brokers who were selling. One was Duncan Priest, who had left FB and moved to the tiny Wellington firm McDouall Stuart. Priest was a mining enthusiast with a taste for Canadian shares. A Friday lunch regular with the Ponzi scheme operator David Ross (though he had no role in, or knowledge of, Ross’s illegal operation), Priest had a small following who shared his hopes for mining shares. Priest and others would ring Hubbard and offer him placements of shares, perhaps with deals that had been sub-underwritten (that is, deals for which the underwriting manager had assigned a junior partner a small portion to sell). Perhaps Hubbard became a sub-underwriter, and picked up sub-underwriting fees, or a share of them. Hubbard developed a habit of accepting only half the share allocation offered by the salesmen. After two such events any salesman would probably then have offered Hubbard double what he was trying to sell. Such games are well understood in the mining share market.
However he acquired his ‘tips’, Hubbard developed an eclectic portfolio of shares and other securities which in theory belonged to individual portfolios held within HMF. In reality he allocated the shares to individuals when he had time or, most likely, when there was a demand for statements. He regularly forgot to invest and would have to manufacture transactions and statements, his wife Jean helping with the administration. Some of these paper manipulations were recorded informally on scraps of paper. Because he wanted everyone to be a winner he underwrote individual portfolios and, like David Ross, glossed up trading gains and portfolios. Unlike Ross, he used his own resources to make up any deficits. Very few, apart from his accounting partners, his investors and the salesmen at broking firms, had ever heard of HMF. In 2010 it was ‘discovered’ by the statutory manager.13
None of Hubbard’s investors had asked why HMF had not registered as a Portfolio Investment Entity (PIE), which would have had tax advantages. Probably none of them realised the fund would not have won such a status. Without a trust deed, trustees, or any outside controls, HMF was unlicensed, and therefore ineligible for PIE status.
Throughout the period Hubbard’s various legal obligations were clearly well beyond the ability of an elderly man to manage. He was the senior partner in a busy, entrepreneurial accounting practice and had at least a thousand of his own clients. He was sole manager of ASL and HMF. He chaired a billion-dollar finance house and was, in effect, its lending committee. He owned 33 per cent of Dairy Holdings, which owned fifty-eight dairy farms and fifteen other farms, and he owned 50 per cent or more of many other deer, sheep and dairy farms. He owned Helicopters NZ, a substantial company, and 80 per cent of Scales, which employed hundreds of people. He owned commercial property. He was a director of no less than 600 companies.
He carried the extra stress of having to conceal his many cover-ups. He shuffled assets to do this. Yet he thrived, continuing to support Presbyterian Support Services and the Boy Scouts and finding new ways to indulge his thrill of the chase. He invested $10 million in a Blenheim company which believed it had discovered a drug that cured Hepatitis C. As he approached the age of eighty, Hubbard became convinced that he was endowed with a special source of inspiration. His fellow director, Nattrass, and his trusted Treasurer, Gloag, both knew what had given him this idea.
Hubbard had told them he had met God during his cancer operation, and God told him, in Nattrass’s words, that ‘Allan Hubbard would be looked after’. This experience in 2007 re-energised him even as he coped with three six-hour dialysis sessions a week. Hubbard believed he had spoken with God when he was on the operating table and received God’s endorsement. Some might interpret Hubbard’s certainty that this meeting was real as evidence of cerebral decay.
Nattrass recalls that afterwards Hubbard spoke earnestly about the experience. Hubbard’s approach towards lending and investing took on a new dimension. ‘I counted at least $150 million of loans he approved to projects connected with religion after Allan had that experience,’ Nattrass recalled. Hubbard was ‘jubilant’. God had given him the power to carry on, regardless of conventions. He said he knew he was on the right track.
But the track forked in 2009. Hubbard found himself heading towards a very different place.