Stanilite Pacific Limited (In Liquidation) & Anor v William Henry Brown Seaton & Ors Trading as Price Waterhouse - [2004] NSWSC 376

No judgment structure available for this case.

Reported Decision:
52 ACSR 646

Supreme Court

CITATION: Stanilite Pacific Limited (In Liquidation) & Anor v William Henry Brown Seaton & Ors Trading as Price Waterhouse [2004] NSWSC 376 revised - 14/05/2004

HEARING DATE(S): 13,14,15,16,20,21,22,23 October 2003 and 2,3,4,8,10,11,15,16,17 & 18 December 2003.

JUDGMENT DATE:
12 May 2004

JURISDICTION:
Equity Division
Commercial List

JUDGMENT OF: Bergin J

DECISION: Amended Summons Dismissed

CATCHWORDS: [Negligence] - Claims that defendants, auditors, were negligent in (a) consenting to the inclusion of unqualified audit opinion on 31 December 1994 accounts of the plaintiffs in Prospectus on 3 May 1995 - and (b) signing unqualified audit opinion in respect of 30 June 1995 accounts of the plaintiffs - Allegations that the use of earned value method of bringing profit on telecommunications contracts to account was inconisitent with relevant accounting standards - Whether such contracts construction contracts - Whether material loss forseeable. [Contract] - Claims that same conduct amounted to breaches of contract. [Statute] - Claims that same conduct amounted to breach of provisions of Corporations Law in force in 1995.

LEGISLATION CITED: Corporations Law

CASES CITED: AWA Ltd v Daniels t/as Deloitte Haskins & Sells (1992) 7 ACSR 759
Daniels & Ors (formerly practising as Deloitte Haskins & Sells & Ors) v Anderson & Ors (1995) 37 NSWLR 438
Mahony v J Kruschich (Demolitions) Pty Ltd & Anor (1985) 156 CLR 522
Onassis & Calogeropoulos v Vergottis [1968] 2 Lloyd's Rep 403
Swiss Bank Corporation v Lloyds Bank Ltd and Ors [1982] AC 584

PARTIES :
Stanilite Pacific Limited (In Liquidation) (First Plaintiff)
SL Electronics (NSW) Pty Ltd (In Liquidation) (Second Plaintiff)
William Henry Brown Seaton & Ors Trading as Price Waterhouse (Defendants)

FILE NUMBER(S): SC 50055/01

COUNSEL: FM Douglas QC, and CE Adamson SC (Plaintiffs)
JH Karkar QC, IM Jackman SC and MR Elliott (Defendants)

SOLICITORS: Deacons (Plaintiffs)
Minter Ellison (Defendants)

IN THE SUPREME COURT
OF NEW SOUTH WALES
EQUITY DIVISION
COMMERCIAL LIST

BERGIN J

13 MAY 2004

50055/01 STANILITE PACIFIC LIMITED (IN LIQUIDATION) & ANOR v WILLIAM HENRY BROWN SEATON AND ORS TRADING AS PRICE WATERHOUSE

Introduction

1 The plaintiffs, Stanilite Pacific Limited (Pacific) (in liquidation) and SL Electronics (NSW) Pty Limited (Electronics) (in liquidation), sue the defendants, William Henry Brown Seaton and others trading as Price Waterhouse (PW) for damages for breach of contract and negligence in acting as auditors of the plaintiffs. The liquidators of the plaintiffs are Kenneth Rennie and Geoffrey James who were partners of Ernst & Young at the time of their appointments and were consultants to that firm at the time of trial.

2 The plaintiffs claim that Mr Seaton, to whom I shall refer as the defendant, and PW, acted negligently and in breach of PW’s contract with the plaintiffs in: (a) issuing an unqualified audit opinion on 16 March 1995 in respect of the accounts of Pacific and its controlled entities, including Electronics, for the half year ended 31 December 1994 (the Accounts), or at least failing to insist on the inclusion of a note to the Accounts in relation to recent correspondence with the bankers (the going concern issue); (b) consenting to the inclusion of the unqualified audit opinion on the Accounts in a Prospectus lodged on 3 May 1995 (the Prospectus); and (c) issuing an unqualified audit opinion on the accounts for the year ended 30 June 1995 (the 1995 accounts).

3 The plaintiffs claim damages on the following bases: (a) in the case of Pacific, the difference between the value of its assets had a receiver been appointed in May/ June 1995, and the value of its assets upon liquidation, together with the dividend paid on December 1995 to its shareholders; and (b) in the case of Electronics, the further trading losses incurred by it as a result of the loan made to it by Pacific from the monies raised by the issue and the placement, which permitted it to incur further expenditure on international telecommunications contracts, and to enter into a contract known as the CTI contract, which rendered it unable to repay the loan to Pacific, and greatly increased its indebtedness to its other unsecured creditors.

4 The matter was heard on 13 to 16 and 20 to 23 October 2003 and 2 to 4, 8 to 11 and 15 to 18 December 2003 when Mr FM Douglas QC and Ms CE Adamson SC appeared for the plaintiffs and Mr JH Karkar QC, Mr IM Jackman SC and Mr MR Elliott appeared for the defendants.

The Facts

5 PW were retained as the plaintiffs’ auditors from 1990 until the plaintiffs were placed into liquidation on 26 August 1996.

The Group

6 The Stanilite Group was founded in 1977 by two brothers, Robert and John Harris, who were managing directors at all relevant times. Shares were listed on the Australian Stock Exchange (ASX) in 1989. Pacific carried on the business as a holding company and raised capital from time to time for the purpose of making loans to its subsidiaries, including Electronics. Prior to 1992 the principal businesses carried on by Electronics were the Emergency Lighting Division and the supply of communications systems for ten frigates built for the Australian and New Zealand navies (the ANZAC contract). In 1992 Electronics expanded its operations into manufacturing and installing telecommunications systems in overseas countries that did not have developed telecommunications infrastructure.

7 The telecommunications systems manufactured, supplied and installed by the plaintiffs included the Cellswitch and Trunkswitch systems. The Cellswitch communication system, the focus of this litigation, was described in evidence as “quite complex” comprising mobile phones or radios at one end with mobile phones, radios or land lines at the other end. The system includes the hand held devices, the antenna, and the cellswitch (described as “not unlike a mini telephone exchange”). Software drives the switch and links the switch to the main network and provides billing information to the operator of the network on a user-generated system. The linkage into the main network may be a cable or wireless connection or it may be a satellite link or microwave. The cellswitch is a component within the system (tr. 583). The telecommunications towers that were constructed were an essential feature to the successful operation of the telecommunications system (tr.319).

The Group’s banker

8 At the end of December 1993 the Group investigated the availability of further funds from its then banker, the ANZ, the National Australia Bank (the bank) and the Hong Kong Bank. The bank was prepared to offer a facility in the order of $35.2 million, some $5.2 million more than the ANZ was prepared to offer. The Group made a decision to transfer its business to the bank.

8 February 1994 facility

9 On 8 February 1994 a Facility Agreement was executed between Pacific, Electronics and other companies in the Group and the bank to refinance the ANZ facilities and to provide further working capital for the increased expenditure on international telecommunications. It was secured by mortgages over real property and fixed and floating charges from all the companies in the Group together with an interlocking guarantee. The Group provided financial undertakings to the bank that, in the main, depended upon a ratio determined by reference to the audited accounts for the year ended 30 June, and the reviewed accounts for the six months to 31 December.

The February 1994 review

10 On 7 February 1994 the defendant wrote to the audit committee of Pacific advising that PW had reviewed the half yearly consolidated accounts of Pacific for the six months ended 31 December 1993 that had been presented to the Board at a meeting on 1 February 1994 (the February 1994 review). In that letter the defendant set out what was described as “matters that came to our attention during the review which we believe are relevant to the directors’ assessment of the accounts”. The letter also stated that the review was not an audit of the accounts and, in the circumstances, no opinion could be expressed on the truth and fairness of the results or the financial position of the Group as disclosed in the accounts.

11 The defendant referred to a number of “errors in accounting” requiring adjustment. One such error was the “carrying value” of a property at 424 Lane Cove Road, North Ryde (the Ryde property) being “significantly above” the independent market valuation as at 20 October 1993. This property was “carried” in the books at $9,947,743 whereas Jones Lang Wootten (JLW) had valued the property on a vacant possession basis at $8,500,000. The defendant advised that directors were obliged to consider the write-down of a non-current asset to its recoverable amount and that based on the valuation, the book value of the property “could be between $700,000 and $1.4 million above its recoverable amount”.

12 The defendant also advised that the costs of $565,000 in relation to a rights issue should be written off because it had been completed and the costs no longer represented a recoverable asset or any future benefit to Pacific. The defendant also referred to the fact that Pacific had received Australian government assistance for marketing activities in Eastern Europe, China and Taiwan in the form of international trade (ITES) grants. After noting that Pacific’s stated accounting policy was to offset government assistance received against the related deferred expenditure, the defendant advised that $145,000 included in the accounts as sundry income from an ITES Eastern Europe grant should not be brought to account in the profit and loss but should be applied to reducing the deferred cost.

13 The defendant also provided advice in respect of what was described as “inconsistent application of accounting standards”. One matter upon which such advice was given was the following:

The profit on the “Argentina project” has been fully taken up in the accounts.

Revenue recognition for projects in Stanilite is normally based on an earned value basis with cost of sales being actual cost incurred at the point of revenue recognition. The profit taken up on the “Argentina project” is clearly inconsistent with Stanilite’s policy for revenue recognition. The profit taken up is $928,000 higher than that under earned value basis.

Moreover, it is arguable that the earned value basis of revenue recognition is not appropriate for telecommunication contracts, such as the “Argentina project”. We understand that these contracts are usually for the supply of discreet items, cell switches, which are manufactured to specifications. Each item is separately priced and capable of being separately costed. The items are also usually homogenous within each contract.

In such a scenario we believe that it could be strongly argued that these contracts do not fall into the definition of construction contracts under Australian Accounting Standards as they are contracts for supply rather than contracts for construction.

Timing of recognition of profits on supply contracts should be based on delivery. On this basis, the profit taken up on the “Argentina project” would be significantly less.

(Ex F: 239-240)

Argentina order

14 The reference to the “Argentina project” in the 1994 review letter was apparently a reference to a contract between Electronics and GTE/CTI (Compafria de Telefones del Interior) in Argentina prior to February 1994. That project led to a verbal order by CTI on Electronics on 30 March 1994. On 31 March 1994, Electronics wrote to CTI to confirm that verbal order for Cellswitch Base Station Equipment in the following terms:

Stanilite Electronics is pleased to confirm your verbal order of the above-mentioned equipment. We understand that the commitment shown by Stanilite in realising your requirements has placed us in a preferential position for your future requirements.

The equipment offered is exactly as previously purchased by GTE/CTI.

Due to the short lead times that are involved with this purchase, we require your written confirmation by close of business today, 31 March 1994.

The delivery schedule, final pricing and order conditions are attached.

We thank you for your business and assure you of every possible co-operation and professionalism in completing our supply.

(Ex F: 368)

15 The conditions attached to the letter included the prices for “1 + 5 stand alone base station ‘Cellswitch’” with a note that 7 complete systems had previously been supplied. Those conditions included the following:

The manpower for installation will be offered in accordance with the “Technical Services Agreement” which is being negotiated between CTI and Stanilite at this present moment. This agreement would allow a per day usage of the available man power to complete the task.

As an indication of cost the per man day rate is offered at $500. This would include the cost of accommodation and living expenses while in the field. Travel expenses are not included. The travel would be supplied either by the CTI group or charged to the group on a cost plus ten percent (10%) basis.

Stanilite have made inquiries with local companies who have labour available to fulfil the installation task. They would work under the control of Stanilite and as best suits the requirements of CTI.

(Ex F: 371)

Capital raising April 1994

16 In April 1994 Pacific raised $15.34 million through the placement of 2,692,000 shares at $5.70 and $411,000 from the placement of 76,570 shares. It raised a further $1.324 million through a dividend reinvestment plan on 29 April 1994 amounting to a total capital raising of approximately $17 million.

Request for increased facilities

17 In September 1994, as required by the Facility Agreement with the bank, Pacific confirmed that the Group had complied with the ratios referred to in the financial undertakings. Pacific also supplied the draft statutory financial statements for the year ended 30 June 1994, to be signed at the board meeting on 15 September 1994, together with an operating budget 1994/1995, a cash forecast for the year to 30 June 1995 and a budgeted balance sheet as at 30 June 1995. The letter from Pacific to the bank dated 13 September 1994 included the following:

However I now propose that there be an increase in the total facilities of $10 million from the existing A$35.2 million (excluding the US$1.0 million) to A$45.2 million. I submit that this requested increase be mainly allocated between Standby Bills and Overdraft/Bills.

…

As you can see we propose that we revert to the original structure with the exception being an allocation of an extra $500,000 to the encashment facility.

I also advance that on completion of a successful share placement during the financial year the standby facility would again revert to the original $5,000,000 and be subject to further review at that time.

(Ex F: 415-416)

18 In response the bank sought clarification of the accounting treatment of certain items. Pacific responded, attaching a revised cash flow forecast which assumed receipt of a new facility from the bank of $10 million in October 1994 and receipt of cash of $20 million in April 1995 from the share placement.

September 1994 audit report

19 By letter dated 28 September 1994 the defendants advised the directors of Pacific that they had completed the audit of Pacific and its controlled entities for the year ended 30 June 1994. That letter attached a report to the directors containing matters “of significance” highlighted during the defendants’ audit (the September 1994 audit report). Pacific responded to the report by letter dated 30 September 1994. The following are the relevant parts of the September 1994 audit report with Pacific’s response in italics:

1. BUSINESS ISSUES

before

· justification for the project. The project should be consistent with and support the business strategies of the group;

· a detailed budget for the cost of the project. This budget should be used as a means of controlling the costs incurred on the project as it progresses;

· an assessment of the return on the project such as a comparison of the present value of future benefits to proposed costs or the payback period of the project; and

· an assessment of the risks of the project.

…

Levels of approval and authorisation for research and development projects should be at least as stringent as for capital expenditure and should involve the board where appropriate. The approval process should be fully and formally documented. Research and development projects should not proceed without prior approval.

Research and development projects should be reviewed in accordance with our observations at paragraph 1.5.1.

1.2 As part of the budget process an itemised R&D budget has been reviewed by the Chief Engineer, Product Manager and the Joint Managing Director.

It is intended to finalise this schedule when the Joint MD returns from overseas. This will detail the budgeted cost of each R&D project including the assessment and cost benefit and risk analysis.

An update of R&D projects will be prepared quarterly and submitted to the full Board as indicated in your paragraph 1.5.

1.3.1 Approval of contract tenders

prior to

The approval process should include an assessment of the risks and benefits of the contract and a preliminary assessment of the return on the project. Levels of approval should be formalised and should involve the board for significantly large contracts with high anticipated tender costs. Tenders should not proceed prior to the completion of the approval process.

1.3.2 Continuous review of contract tenders

The accounting policy adopted by Stanilite for contract tender costs is to capitalise and defer such costs where in the opinion of the directors it is probable that the company will succeed as a primary or secondary contractor. Whilst deferring contract tender cost is acceptable accounting practice it is usual for listed companies to adopt the more prudent policy of writing off tender costs as incurred.

The directors should continuously assess the likely success of tenders with significant associated deferred costs. Costs relating to tenders which are unlikely to succeed should be fully written off immediately.

…

1.3.3 Reclassification to research and development

Where contracts are not won, tender costs are often reclassified as research and development costs. This is acceptable to the extent that the tender costs include expenses directly related to product development/improvement. Care should be taken to fully analyse such costs before determining the amount to be transferred to research and development to avoid capitalisation of costs which have no on going benefit to the group.

We feel that the reclassification of tender costs to research and development should undergo the same formal approval processes which should be implemented for new research and development projects.

1.3 Similarly Contract Tender costs are required to be approved by Executive Directors before each tender cost is incurred.

Board papers on these costs will also be co-ordinated quarterly and Directors assessments make each quarter and half-year. Any reclassification of tender costs to R&D will also be referred to Board for due diligence as required.

1.4 REVENUE RECOGNITION

1.4.1 Revenue recognition for telecommunication sales

Telecommunications have become an important part of Stanilite’s business. In the year ended 30 June 1994 telecommunications sales contributed 36% of the group’s revenue. Telecommunications sales are expected to grow significantly in 1994/95.

Broadly, Stanilite’s telecommunication sales take the form of either supply of products or construction contracts.

Consideration should be given to formalising the revenue recognition policy for telecommunications sales. Specific criteria for identifying each type of sales should be formalised and the appropriate revenue recognition policy applied. The process of identifying each type of contract should be implemented at the point of winning the contract, properly documented and signed off by project and finance managers.

We believe that the following criteria for defining telecommunication sales types and the related accounting treatment should be adopted.

Supply of products:

Accounting convention requires that revenue for such contracts be recognised as each item is delivered and acknowledged as received by the customer.

Construction contracts:

These contracts may be brought to account under the “earned value” basis. However, there should be a formal non-cancellable contract to support revenue recognition under this basis.

Profit takeup on projects is currently determined by the project department. There is no independent detailed review of projects profit takeup. We believe that several significant errors in projects profit takeup, (including ANZAC) which were identified at the half-year review and during the year end audit, were a consequence of the lack of independent detailed review at each month end.

We feel that it would be appropriate for profit takeup on projects to be determined, at the first instance, by the finance department. This is because profit takeup on projects involves the application of accounting concepts and standards.

The profit takeup on projects at each month end should then be reviewed in detail by the projects department to ensure that revenue recognition is consistent with their understanding of the progress of the projects.

Independent detailed review on a monthly basis of projects profit takeup would ensure that monthly management accounts are a more reliable indicator of the performance of the group and its financial position.

…

1.4.3 Consistent application of earned-value calculation

The method for calculating the earned-value on several projects for the year ended 30 June 1994 had been altered resulting in the earlier recognition of revenue on these projects.

The change in the method involved breaking the project down to its constituent components and treating each of the components as a separate project. This treatment is inconsistent with prior year application of the earned-value calculation. The change was also not applied to all projects but selectively to certain projects.

We believe that unless a project is very large and spans several years (such as the ANZAC frigates project) there is little justification to treat each of its components as a separate project for earned-value calculation. We recommend that a formal policy be implemented for the identification of projects to be broken down into its constituents for determination of earned-value. This policy should outline the criteria which would qualify a project for this method of earned-value calculation and include formal approval by both projects and finance management.

Revenue recognition for telecom sales comments are noted. Subject to any unique specifications the supply of product will be treated in accordance with accounting convention

Where telecoms sales are of the type described as construction contract it is intended to account for these under the earned-value basis.

A simple procedure for determination of such contracts is to be finalised and circulated to the marketing executives to ensure proper understanding of accounting procedures.

With respect to revenue recognition in the area of projects, your comments are very relevant and have been discussed between the finance and projects departments. The amount of time and effort of all parties in reviewing, adjusting and correcting project revenue calculations at year-end was unacceptable.

The finance department must determine profit takeup initially and these calculations reviewed and signed off by the projects department. The endorsement of this approach has been affected by the Executive Directors.

1.5 INTANGIBLE ASSETS

Whilst the papers presented by management provided useful information on the nature of the projects involved they did not always include a comprehensive case supporting the carrying value of the intangible item.

We feel that the inclusion of the following additional matters in the papers would assist the board in assessing the carrying value of intangible assets:

· the stage of completion of the project and the estimated date of completion;

· the estimated cost to complete the project;

· expected future revenue to be generated from the items;

· the likelihood of the future revenue being achieved;

· the period over which the revenue will be achieved. This should determine the period over which the intangible asset is amortised.

every

1.5 Comments contained under intangible assets are again

noted and as previously mention, agreed. Senior management will be instructed to support the collation and justification of amounts capitalised.

1.7 PROVISION FOR BAD AND DOUBTFUL DEBTS

There is no provision for bad and doubtful debts. Our audit indicated that there is a minor exposure to potentially doubtful and disputed debts.

Although all known bad debts have been written off, some minor disputed balances have not been provided for.

Consideration should be given to creating a general doubtful debt provision to cover potential bad and disputed debts which are not covered by the bad debt insurance.

1.7 Subject to a comprehensive review of the status of debtors accounts at December 1994 and June 1995 an assessment as to the level of provision will be determined.

Where appropriate and available credit insurance on international orders will be put in place. There is no bad debt insurance cover on general trade debtors.

(Ex. F: 430-435) (Ex. F: 449-451)

Increase in facilities

20 Pacific wrote to the bank on 30 September 1994 and referred to the acceleration of payment of creditors compared to the previous year. It advised that it currently monitored “very closely the extent to which creditors can be paid without damaging reputation” and advised that it was “judged commercially and in the overall scheme of things” to be more appropriate that “our bank and not the creditors facilitate working capital requirements”. The suggestion was made that there might be a restructuring of the new facility excluding the chattels lease.

21 An internal bank document of 13 October 1994 noted that the Group did not generate sufficient cash flow from operations to cover its operating and tax costs and a shortfall of $7.163 million was noted. The document also recorded the view that there was no cash available to cover any financing costs, interest and dividends, any debt amortisation, or any capital expenditure and that borrowing or equity was required to cover those needs. It referred to the fact that the business had to borrow money to pay dividends of $3.7 million in 1994.

22 Another internal bank document of 13 October 1994 included the following:

In view of the fact that Stanilite does intend to go to the market late this financial year and our increased assistance is to be short-term, we believe that the Board should pass a resolution of intention to raise equity prior to release of further bank funds. The timing therefore is at their discretion but must be before expiry of the short term facility.

We believe that Stanilite should be informed that the equity raising is imperative and that this will be the maximum of our assistance until such time as equity has been raised.

(Ex. F: 523-524)

23 On 20 October 1994 Pacific sent to the bank a Certificate of Compliance with Financial Undertakings, the covering letter of which highlighted that one of the undertakings (1(d)) exceeded the 5% of total assets of the Group. The explanation given was that the increase in assets in New Zealand was represented by work in progress in relation to the ANZAC contract and that it fluctuated significantly “depending on the earned value recognition” and the subsequent invoicing and payment by the prime contractor. The letter requested a “formal written exception to the technical breach of undertaking 1(d)”.

24 By letter dated 3 November 1994 the bank advised Pacific that it wished to continue its support provided an underwriting agreement for the proposed share placement was in place before the funds were released. It expressed the belief that “proposed growth in 1994 and 1995 may become a problem unless some issues are addressed now”. The bank called for a report from the “External Accountants” on certain matters including how much work in progress was written off prior to translation, whether there was obsolete technology still capitalised and a commentary on the country risk strategy. It suggested that the overseas subsidiaries be included in the interlocking guarantee because of the increasing volume of business being done “off-shore” and suggested that an undertaking in this regard would be “sufficient” because the bank did not wish to “hold up release of funds on the technicality of this point”. The bank also advised that the irregular position of the trading account had been adjusted pending a formal approval of an underwriting agreement and requested that such limits be respected.

25 Pacific responded to the bank by letter dated 8 November 1994 enclosing a letter from BBY Corporate Services (BBY) agreeing to underwrite the future capital issue “as and when determined by the Board of Stanilite”. It advised the bank that it “broached with” PW its requests for a report and that it would be meeting with them on 8 November 1994 to discuss the matters in more detail. The letter concluded: “As you can appreciate the requirement for some of the requested increased facilities is now pressing and we would appreciate the formal release of funds at your earliest convenience” (Ex G: 9161-9162).

26 On 16 November 1994 a meeting was held with representatives of Pacific, the defendant and representatives of the bank including Mr Treadwell and Mr Ray Pridmore from the credit bureau of the bank. A note made by the defendant of that meeting included the following:

Need for capital raising noted by Pridmore – asked if I thought a large (30-50 m) rights issue could be made – I said could be possible if “good news” could “excite” buyers. …

I noted that much of the telecoms revenue is likely to be lumpy.

(Ex. G: 9165-9166)

27 The defendant’s note also referred to the requirement for the defendant to produce a draft letter setting out items to be addressed. That letter was provided on 17 November 1994 in which the defendant set out the issues upon which PW was required to report and advising that the report would be available by 22 November 1994. The letter noted that Pacific was revising the 1995 cash flow forecasts that would be provided to the bank after the December Board meeting.

The Russian Contract

28 On 11 November 1994 Electronics and Techin Trade Limited entered into the Techinfo Network Supply Agreement (the Russian contract) (Ex. F: 533). The details of the terms of this contract are dealt with later in this judgment when I am considering the plaintiffs’ detailed allegations against the defendants in respect of their treatment of the revenues from this contract utilising the “earned value” basis. In general terms, this contract was for the supply of products (equipment) and services. The equipment was cellswitch systems, microwave links, billing system hardware and user terminals. The services included the provision of modifications to the existing switching system, the provision of modifications to the existing equipment, the provision of in-country support, the provision of site preparation works, including foundations and fixings, the provision of building works, supporting structures and power supply points, the provision of transport and the provision of site labour for installation and set to work (Ex F: 533).

The bank visits the Group

29 On 19 November 1994 Messrs Pridmore and Treadwell visited the Group’s premises. Mr Pridmore’s rather colourful file note of the visit included the following:

(Ex F: 646)

30 Mr Pridmore went on to note that one danger for the company was its ambition, “taking them into a league with major players who have, thus far, ignored them as of no significance”. He also noted that the R&D requirement was likely to become greater and greater in future years and continued:

This is going to require very careful management and a specific focus for R&D which is not currently apparent. Again, the absence of a strong, pragmatic personality to restrain enthusiasm could be a cause for concern.

(Ex F: 648)

31 Mr Pridmore referred to the Cost Schedule Control System, known as CS2, that had been installed and noted that it was the only company that had installed it, “not for a single contract, but now apply it to every contract undertaken by them” and continued:

The result is that the company has had imposed upon it a magnificent system that has almost certainly been the making of them since it has ensured that they did not suffer the lack of controls that attends almost every other rapidly expanding company.

(Ex F: 649)

32 He noted that under this system, profit to date on a contract could not be taken as indicating overall profit expectation and that there may be recognition of substantial profit on an element of the contract with no prospect of payment for some time. He also noted that where costs change, allowing the company to improve its margin on the contract, the whole of those additional profits are brought to account immediately, notwithstanding that most of the contract may not yet have been completed. He referred to this aspect as very “misleading” and one of which the bank should be aware.

33 In dealing with inventories Mr Pridmore noted that $10 million were actually “Cellswitches for which there is no current customer” and that $5 million were in the form which were “generic”, able to be used anywhere once an additional 10% of work was completed to “customise” them for specific areas. He then noted:

All of the above points should be of concern to the bank since the great majority of stock and raw materials carried would have an extremely low sale value if, in fact, they could be sold at all. Similarly, WIP has almost no intrinsic worth since it is merely part of contracted work which almost certainly would not be purchased if a third party had to complete the contract.

(Ex F: 650)

34 Mr Pridmore observed that “intrinsic value in the absence of the continuing operation is very small”. He suggested that the bank needed to “seek comfort concerning the continuing operation of this company since asset values will be sustained only by the on-going business” (Ex F: 651). He noted that one thing that had become clear in conversation was that: “any equity raising of $20 million can be no more than a short term palliative and is most unlikely to fund the company through to June 1996” (Ex F: 652). He then referred to his meeting with the defendant and recorded that he impressed him as being pragmatic, understanding of the bank’s concerns and knowledgeable of both the operational and financial position and systems of the company. He expressed a belief that the defendant could be relied upon to provide accurate, independent assessment of the accuracy and reliability of the data contained in the CS2 and to provide the bank with the necessary comfort to support extension of the facilities. He noted that the defendant would comment upon and verify the new cash flow to be tendered on 6 December 1994.

35 Mr Pridmore recommended that subject to a satisfactory report from the defendant the bank should provide further facilities sufficient to support the “new cash flow” on certain conditions. Those conditions included the overseas subsidiaries becoming guarantors; the obtaining of trade indemnity insurance satisfactory to the bank; appropriate covenants to be decided in the light of the cash flow; and future reporting to the bank on a quarterly basis to include detailed management reports and copies of the project performance report for each contract with various details as required. He suggested a standby facility of $5 million on a short-term basis, the drawings for which would have to be preceded by an “acceptable” report from PW attesting to and analysing the information contained in CS2. He considered the option of transferring the account to “Corporate Banking” but allowed it to remain where it was on the basis of the adoption of the monitoring mechanisms referred to in the file note “together with the involvement of Price Waterhouse”.

The defendant’s report for the bank – 22 November 1994

36 The defendant produced the requested report dated 22 November 1994 for use by Pacific and NAB for the purposes of reviewing the banking facilities. That report included the following:

The project WIP balance is made up of the cost of work in progress plus attributable profit to date less progress claims. Attributable profit is determined on percentage of completion estimated using the earned value basis under the Cost/Schedule Control Systems (C/SCSC) methodology (refer Paragraph 5.1). A schedule of progress claims or billings is however usually outlined in the contract for projects which would include specific points at which invoices may be rendered. The project WIP balance in effect represents the degree to which progress on the project is recognised in advance of billings.

(Ex F: 662)

37 Paragraph 5.1 of the report was in the following terms:

5. PROFIT RECOGNITION ON PROJECTS

In simplistic terms the company adopts the “percentage of completion” method of profit recognition. This method results in profits accruing over the life of the project and being reflected in revenues and gross work in progress valuations in the accounting records.

On all contracts cost schedules control system (C/SCSC) procedures are adopted. These have the effect of breaking the contract down into “definable work packages” which are each assigned costs and selling values at the start of the contract. The number of work packages varies by project but may be numbered in thousands such as in the ANZAC contract. At period ends (normally monthly) the stage completion of each package is determined and earned value of each package is established. The aggregate of all packages produces the overall project result.

The selling values ascribed to each work package does not necessarily result in the same margin % by package-inherently, more valuable processes or processes with greater risk/return profiles may attract greater margins than simple build packages. Therefore the margin earned on a project will vary over its life depending on the nature of the tasks being undertaken.

The establishment of completion levels of each package ideally is by reference to physical completion or achievement of identifiable “milestones”. However, on the smaller and simpler projects the work packages completion is established through traditional measurements, such as percentage of costs incurred versus final estimated costs or, if more appropriate, hours spent as percentage of final estimated hours.

(Ex F: 665-666)

38 The report also referred to margins since 1 July 1994. The lower monthly gross profit margin compared to the margin for the year to 30 June 1994 was attributed in part to the greater proportion of profit take-up on “high margin telecommunication projects and the ANZAC contract in the year to 30 June 1994” and that, “to date no major telecommunications contract has been reflected in the results whereas 1994 included the very profitable Argentina contract”.

The ASX announcement of the Russian contract

39 An ASX announcement of 23 November 1994 referred to the Russian contract of $37.5 million for the supply of “22 site cellular telephone systems, the first elements of which were shipped upon finalisation of the agreement”. The announcement also stated that: “microwave links, switches, terminals and integration of the system into the Russian telephone network are also being provided” that would ultimately support 10,000 subscribers in the Black Sea region of the Russian Federation. It also suggested that the second consignment of systems was to be shipped later that week with Electronics’ engineers departing for Russia within hours of the contract’s signing.

The defendant’s December 1994 letters

40 On 5 December 1994 the defendant wrote to Pacific advising that he had made a number of “principal assumptions”. He asked the Board to review and confirm that those assumptions were both appropriate and correct and advised that his report for the bank would state that he had reviewed those assumptions and had no reason to consider them to be inappropriate. However he advised that he would clearly state to the bank that the responsibility for setting the assumptions was with the Board and management. Those assumptions included the following:

11. Cash receipts from debtors

(i) Telecommunications

It is assumed that, excluding the Techin Russia contract, total domestic and international communications receipts will grow from approximately $1m/month in the last quarter of 1994 to approximately $5m/month in the first quarter of 1995 and to approximately $6m/month in the second quarter of 1995 based on existing prospects, rated by likelihood of success. It has been assumed that the majority of the sales will be on contracts with individual values under $5m and that no individual contract will generate more than $4m in cash receipts in the period to 30 June 1995.

(ii) Telecommunications - Russia

It is assumed that Techin will be able to repay its commitments in accordance with indicative revenue generation schedules contained within the contract. In particular, it is assumed that Techin will be successful in generating US$22.6m from sales of terminals in the period December 1994 to mid February 1995.

(Ex F: 681)

41 On 7 December 1994 the defendant wrote to the directors of Pacific in respect of the “forecast receipts and payments” in terms that included the following:

Qualification

The forecast receipts include in aggregate $33,919,000 under the caption “Telecommunications International-Russia” in respect of the Techin Trade Ltd contract for the supply of goods and services under the Techinfo network supply agreement. As indicated in forecast assumption 11(ii) on Schedule 2, the receipt of these monies is dependent on ability of the network operator, Techinfo, in which Techin Trade Ltd has majority interest, to generate revenues principally from the sale of terminals to be supplied by Stanilite.

We have been unable to independently assess Techinfo’s ability to generate the revenues within the timeframes assumed and accordingly we are unable to determine whether the assumptions in respect of these receipts provide a reasonable basis for the forecast.

(Ex F: 740-741)

42 On 13 December 1994 the bank wrote to Pacific referring to the defendant’s report and advised that the bank’s credit bureau would require a cash flow based on the assumption that no funds are received from Russia and “you cease supply and replacement stock” because the revenue from Russia was dependent upon the ability of Techinfo to generate sales of terminals within Russia.

43 On 20 December 1994 Pacific advised the bank that insurance cover had been obtained for the Russia contract; that payment would be made by Techin Trade, a US company; that a charge had been taken over the available assets in the US; that title to the goods did not pass until they were paid for; that shipments of goods from Australia were being made according to plan; that the value of the equipment currently held in Istanbul was US$2.547 million; and that 2 Cellswitches had already been installed in Russia. Pacific also advised that an equity raising was likely to follow the release of the half-yearly results, which was usually at the end of February. Pacific also advised that it saw no difficulty in meeting that timetable because due diligence was already underway.

The cashflow

44 A cashflow prepared by PW, apparently in December 1994 (Ex F: 760), showed receipt of $18.8 million from the Russian contract in January 1995. It appears the bank reviewed this document and an internal file note of 30 December 1994 included the following:

Our concern stems from the cash flows provided by the company on 23 December … They confirm the parlous state of the company’s forward cash position and is well beyond the extra $10m that the company had earlier sought to cover its needs. Based on the company’s own figures the very best position that the company faces, which involves the receipt of payments under the Russian contract of $18.8m in January 95, a situation with the contract we feel is remote in the extreme, requires further excesses of approx. $8.0m to a total of $15.5m peak in January 95. Other scenarios presented reveal a much worse position so far as excesses are required!

In the scenario that the Russian contract is immediately stopped now with no further expenditure by the company and no receipts under the contract in the period of the cash flows (June 95), the peak debt reaches $21.6m – a further $14.2m on the position as it stands at present. The worst position so far as the excesses are concerned is if the Russian buyer opts to avail of the delayed payment option under the contract and delays payment until August 95. Expenses continue during that time in meeting delivery obligations to the contract. Peak excess is projected then to reach $31.0m in February 95. It is clear from the above that the Bank is now placed in a most invidious position. Our only exit would seem to be through a share placement/rights issue of a minimum of say $35m. This is something to which the company has not yet committed and in fact in its cash flows have projected a raising of only $20m.

(Ex F: 764)

45 The note went on to refer to the rampant inflation in Russia and the extreme likelihood that the buyer would avail itself of the delayed payment regime under the contract. Reference was also made to the bank’s “grave misgivings” as to whether the Russian company would receive sufficient income to meet its payment obligations to Electronics. The bank concluded that it was of “critical importance” that the receipts under the Russian contract be fully insured. It was noted that the account warranted the most careful monitoring and attention until the bank had a much clearer picture of a number of matters including: details of the level of expenditure on the Russian contract; confirmation that the cash flow projections remained sound; clarity in respect of the proposed equity raising; full details of the insurance cover held for the Russian contract; details of the Russian buyer and how it intended to cover its exchange risk and all other obligations under the contract; and information as to whether the buyer had exercised its option to avail itself of the extended repayment terms.

The 4 January 1995 meeting with the bank

46 On 4 January 1995 representatives of the bank met with the managing directors of the plaintiffs and the chief financial officer. The bank suggested that the equity raising should be at least $40 million to give the company enough capital to survive the current cash flow problems. The bank expressed concerns about the Russian contract and the possible exposure of the plaintiffs. It was noted that the insurance cover was only 60% of $7.4 million of a total contract value of $33 million, however after discussion about the capacity of the plaintiffs to “stop supply” the matter was not taken further. There was also discussion about the delays that had been experienced in the deliveries for the Russian contract by reason of storms in the Black Sea region. The bank indicated that it should not fund large deliveries under the Russian contract until a legally binding underwriting agreement in respect of the equity raising had been sighted.

The January 1995 facilities

47 On 12 January 1995 the bank advised Pacific of its willingness to provide facilities including a $10 million temporary overdraft to be available until 31 March 1995 on the condition that steps be taken to raise additional equity of at least $35 million, such funds to be used to clear the temporary facility. The bank also advised that a further $5 million would be made available on request but only after entry into an underwriting agreement acceptable to the bank covering an equity raising of at least $35 million. The bank required special undertakings and reporting requirements including the following:

1. That with regard to the Russian contract, the company will, from this day forward, restrict expenditure in relation to that contract to not exceed total actual receipts of revenue from that same contract. This condition is to continue until the equity monies are received when we would consider a review of the arrangement in the light of circumstances then existing.

(Ex F: 800)

48 Pacific responded to the bank by letter dated 13 January 1995 pointing out a number of areas of disagreement with some of the comments made by the bank in its letter. Pacific advised that expenditure on international telecommunication projects was “aligned with identifiable opportunities” and although it presented “timing problems” the Board was conscious of and satisfied with, the “level of prudential risk”. The letter also included the following:

(d) In relation to the Russian contract which we presume has given rise to some unease within the bank, we make the following comments:-

(i) a condition precedent was EFIC cover on the first phase of the contract which was agreed by EFIC at 60% of invoicable value up to US$7.4 million. This cover exceeds Stanilite’s costs and EFIC have stated that they are prepared to extend the cover as the contract proceeds.

(ii) There is no Russian currency risk to Stanilite as our contract is with Techin Trade Limited (Delaware USA) and is expressed in US dollars.

(iii) Title to the equipment does not pass until payment in full.

(iv) Extensive due diligence on the Russian parties was carried out by appropriate government agencies to the satisfaction of Stanilite’s management.

(v) The technical nature of the installations are dependent for successful operation on ongoing Stanilite involvement and equipment.

(vi) The company has forwarded to the bank evidence that the security over various US assets detailed in the contract have now been filed with the various government departments.

(vii) We have also negotiated an additional security for US $1.5 million in the form of an undertaking from the NSTP (Russia) to provide an irrevocable letter of credit drawn on an acceptable UK or European bank.

(viii) The company has already had experience in Russia and CIS through Millicom International Cellular (Luxembourg) which, although not nearly of the dollar value of the TTL Russia contract, have been technically and financially successful.

(ix) As previously advised to the bank, should revenue not flow as expected and required under the Russian contract, no further commitments will be made and equipment is recoverable with EFIC cover underwriting any losses.

(Ex F: 809-810)

49 On 16 January 1995, at the request of the chairman of Pacific, a further meeting was held with the bank. The purpose of the meeting was to advise the bank that the equity raising could not be concluded by 31 March 1995. Pacific requested an amendment to the timetable imposed as a condition of the provision of the facilities. The bank wrote to Pacific on 16 January 1995 amending its requirements to provide for “a clear and unequivocal resolution” by the Board to immediately put in place arrangements to enable the company to raise additional equity of at least $35 million and for the company to “use its best endeavours” and good faith to achieve an acceptable underwriting agreement by 15 March 1995 for an amount of at least $35 million. On 18 January 1995 BBY advised Pacific in writing of its willingness to underwrite an equity issue of $35 million subject to the pricing of the issue and the pricing not being detrimental to the best interests of Pacific.

50 On 19 January 1995 Pacific sent to the bank a copy of the Board resolution accepting the bank’s offer for the $15 million overdraft facility on the terms and conditions imposed by the bank. That resolution also included the agreement that the first $15 million of the capital raising would be applied to the repayment of the $15 million overdraft facility and that in the absence of a capital raising, a plan would be produced to enable repayment of the $15 million by 31 December 1995.

51 On 30 January 1995 at a meeting of the Due Diligence Committee, at which the defendant was present, consideration was given to the option of completing full audited accounts for the half year ended 31 December 1994, instead of the planned review of the Accounts. The defendant advised the Committee that the time needed for a full audit would impede compliance with the key dates provided to the bank. Notwithstanding that advice, it was agreed to recommend to the Board that a full audit of the Accounts be carried out and that the timetable should be discussed with the bank.

52 The capital raising was to occur in an environment where Pacific’s share price had been “at recent historical lows” and BBY assessed that the group was “in a corner” with the bank in relation to the requirement to pursue the capital raising. In presenting the possible “scenarios” for the capital raising BBY concluded that there would be “uncertainty” in the outcome with a need for a heavy sweetener to the possible detriment of the company and the shareholders. BBY concluded that the bank was exerting “excessive influence” on the funding strategy and recommended a review of the bank terms and a relaxation of them as soon as possible with alternatives for additional debt funding being pursued immediately (Ex. F: 829).

53 By letter dated 25 January 1995 Pacific provided the bank with a revised cash forecast for the period January to December 1995. The explanatory notes advised that the project revenue from the Russian contract had been “rephased” to allow for time delays experienced through Christmas and the Russian New Year period. The notes also included the following:

(g) Russian project expenditure rescheduled and payment in January of $450k covers actual commitments. No further commitments will be made until revenue forecast in February is progressively received.

3. The revised cash forecast shows that, based on anticipated revenues from operations and the successful completion of the $37 million Russian project now by August/September (a delay of 1 month from the original plan) the increased facility of $15 million will be repaid to the bank by end of October 1996. This is in the absence of any capital issue. However it is realistic to anticipate that there will be continual changes to the cash forecast (as required to be updated to bank monthly) and the company will continue to liaise with the bank on all issues influencing changes to the cash forecast.

(Ex. F: 839)

54 Pacific also advised the bank that there had been a decision to proceed with an underwritten equity issue for an amount of $35 million and to have the net proceeds available in full before the end of April. It also advised the bank:

The determination of this scenario to suspend the project will be made in February.

However, EFIC insurance of 60% of the invoiced value to date of approximately $4.0 million would be claimed and receivable in September. This would bring the net reduction in the closing balance to around $6 million from $13.9 million to $7.9 million in funds.

(d) Planning is in progress to “project finance” the Russian contract. On the expectation that revenue is received from the sale of terminals etc in accordance with the contract, the objective is to accelerate the project financing of the initial phase one. This would include the immediate reimbursement of invoices issued (to date equivalent A$4.0 million) and advance payment for a discounted profit to Stanilite on a non-recourse basis.

If achieved by April, this would accelerate the revenue (forecast $8 million) at a net cost of $1.4 million for eliminating risk. The ongoing success of the project would enable the funding to the next stages of the network and as such provide Stanilite with commercial payment for goods and services provided.

(Ex F: 840)

55 Pacific also advised the bank that depending upon revenue inflows, executive management would have to consider the process of reducing inventory purchases during February and beyond. It also advised that there would be a controlled reduction in salaries/wages and operating costs across the board to accommodate timing delays in receipt of orders from March onwards. A plan for the sale of rights of future revenue streams from various R&D projects with the retention of proprietorship of the intellectual property in those projects was also discussed.

56 On 6 February 1995 Mr Pridmore reviewed the revised cash flows and recommended that certain elements should be disregarded by the bank. One of those elements was:

The Russian contract yields a surplus cash flow of $8.5M. Even the company is not entirely certain that payment will be received and arrangements have been made to stop all further payments other than those covered by receipts. As such, both payments (other than those already made) and receipts should be removed from the cash flow.

(Ex F: 871)

57 Mr Pridmore referred to the prospect of the overdraft exceeding $10 million if certain adverse events occurred and after referring to the prospect of insurance claims, reduction in inventory and the sale of all or part of three R&D projects, he noted:

No detailed knowledge is held concerning the above assets, their selling value, potential buyers, etc. In this connection, given the short time before the additional funding is required, it seems likely that we will have to take on trust the company’s statements concerning their value.

This is, however, only a fall back position. Repayment will actually be looked for from (in order of priority):

Only if all of the above fail will the bank be looking to some form of down-sizing in order to achieve repayment of the final $10M.

(Ex F: 872)

58 On 7 February 1994 the Due Diligence Committee was advised that the Board had agreed that a full audit of the Accounts was to be carried out. Mr Chan, from PW, advised the Committee that PW planned to provide full audit clearance by 10 March, “but should be able to give an audit clearance to enable the half year’s results to be released to the ASX by 1 March 1995, provided that there were no material issues outstanding”. It was noted by the Committee that “as the comparative figures for 1993 were not audited” PW would be providing their “normal engagement letter to the company in respect of this audit” (Ex F: 874).

8 February 1995 retainer for audit

59 On 8 February 1995 the defendant wrote to the directors of Pacific in respect of the audit of the Accounts. That letter included the following:

Our audit

Our audit will be planned primarily to enable us to form our professional opinion upon the state of the company’s affairs and its results and to report thereon to the members of the company in the terms required by the Corporations Law and AASB 1029.

(Ex F: 877)

60 On 13 February 1995 the bank notified Pacific that all pre-conditions of approval detailed in its letter of 12 January 1995 had been met and that the extension of the overdraft facility to a maximum of $15 million was available. In approving the full use of the facilities the bank noted that “cash flow is very vulnerable”, but that it had “some fall-back strategies that can be adopted if expected revenues do not materialise as planned” (Ex F: 893).

61 On 20 February 1995 the defendant advised the Due Diligence Committee that PW were “on target to provide adequate comfort to the Board by 28 February” (Ex F: 903).

62 On 21 February 1995 the bank noted that Pacific had not complied with some of the conditions imposed as “special undertakings and reporting requirements” in the letter of offer of 12 January 1995. In an internal memorandum the following was noted:

We do not accept the company’s reasons for extending its expenditure budget for January and we can only reiterate our desire for strict expenditure control. One of the reasons for requiring the rolling cash flow forecasts is to ensure that any excess of expenditure in any particular month(s) is/are offset by savings generated in future months so as to ensure that the full year result is kept within the original budget. Conversely with revenue; any shortfall in revenue in any particular month(s) is/are caught up during the remainder of the year.

To have invested so much time and effort in endeavouring to get to a position where we were comfortable to go forward and having signed off with the company as to the terms and conditions for our continued support, to be in the first month of the new accepted program and for these problems to have occurred at such an early stage, is disappointing to say the least. We must stand firm and make sure that we call the shots with this customer, particularly at this time when we are most at risk (ie, before the equity raising has come to fruition). If we back off at this early stage, we have lost the benefits that we have strived so hard for over the past few months.

You probably have seen the attached report from the AFR today which talks about the potential for a $1b radio system for India. Would you please endeavour to find out how this deal will be structured, financed etc as we do not wish to be faced with another situation as we were with the Russian contract. We consider the company to be a little naïve when dealing with these types of commercial transactions and the earlier we can obtain information about them, the more we may be able to guide them as to proper prudential controls/mechanisms etc.

(Ex F: 905)

63 The legal firm Corrs Chambers Westgarth (Corrs) provided advice to the Due Diligence Committee in relation to the Group’s various contracts and whether they should be included in the Prospectus. In respect of the Russian contract, Corrs noted that they had been instructed that the Due Diligence Committee was to receive a management briefing on the transaction and advised:

It is our preliminary view that this is a material contract for inclusion in the Prospectus, given the contract price for Phase 1 (i.e.$US18,648,638.00) the importance of the agreement for prospects of Stanilite and the need to update potential investors on information provided to the ASX and the media.

(Ex F: 948)

64 On 1 March 1995 an “update” on the Russian contract was provided at a meeting of directors of Pacific at which the defendant was in attendance. The Minutes note that the project was “currently six weeks behind schedule, but most of the initial problems with the client were now overcome and the project was proceeding with completion expected by December 1995”. It was also noted that the original cash flow and business plan were being reviewed and a number of contract variations were required. The PW engagement letter was tabled as were the results for the half-year. The defendant is noted as having “indicated that there was still a lot of work required to complete the audit and resolve the issues raised during the course of the audit “. The Minutes also contained the following:

The net profit after tax was $4,238,000 and this compared favourably with previous forecasts.

Mr Fayle reported on the adjustments made to the accounts as a result of the audit and discussed revenue and profit from the Russian project brought to account and also outlined the rationale behind the deferral of marketing costs. Full justification papers were being prepared which would form part of the working papers for the accounts.

After discussion and on the understanding that the outstanding issues would be resolved without any major amendment to the profits, the board agreed that an unaudited profit after tax of $4,328,000 was appropriate and should be advised to the ASX by Friday 3 March 1995, together with an appropriate covering letter to be prepared by management and reviewed by the Board.

(Ex F: 964)

Announcement of half-year profit to the ASX

65 On 3 March 1995 Pacific made a “Half Yearly Announcement” to the ASX advising that the Chairman, Mr John Valder, “today announced a profit after tax for the half year to 31 December 1994 of $4.238 million” representing a marginal increase on the previous comparative period’s net profit of $4.213 million. The announcement advised that telecommunications experienced a 36% increase in sales revenue and an even greater increase in contribution during the six months to 31 December 1994 compared to the first six months of the previous financial year. It also included the following:

The winning of a contract with Techin Trade Limited of the USA to supply a A$37.5 million turn-key cellular telephone network initially in the Black Sea port area of Russia. Significant progress was achieved in this project in the current reporting period. Completion of the project for an initial 10,000 lines will be by the end of 1995, after which an extension of a further 20,000 lines will be made.

(Ex F: 967)

66 Also on 3 March 1995 BBY published the interim result for Pacific that included the following:

The interim result has highlighted the company’s need for capital to meet the growth of its telecommunications business. While its cash flow requirements may hold back performance in the short-term, we believe that the company can still deliver above-average EPS growth over the long term.

…

Net profit after tax increased marginally to $4.238m from $4.214m for the pcp. This was earned on sales revenue of $48.2m up 17.7%. The result was assisted by a lower tax charge for the period due to R&D reductions.

The result was impacted by accelerated amortisation charges and increased interest costs.

A flat dividend of 3c unfranked was declared for the half.

…

Revenue from the telecommunications division increased significantly; it is expected to rise strongly in the second half with deliveries for contracts including China, Russia and South America. This is the fastest growing, but most capital hungry side of the business. The working capital required for projects the size of Russia, combined with the continual demands for R&D funds has led to a significant drain on cash flow.

…

Operating cash flows were down dramatically reflecting the build up for the aforementioned projects, and the fact that some of the longer-term projects are accounted for on an earned value basis which does not always reflect the cash flow position of the contracts. It is becoming increasingly difficult to predict the cash flow requirements of the group under this method of accounting. While the earned value recognition of earnings is an accepted accounting standard, the company will need to shorten its payment milestones to better reflect the requirement for cash.

(Ex F: 984-986)

67 After referring to the options of capital raisings of $20 million and noting that the size of any capital raising would depend on the level of debt the Board felt comfortable with, BBY concluded that the outlook for Pacific remained exciting because many countries in the developing world were considering essential investment in basic telecommunications services and Pacific had positioned itself well to take advantage of such opportunities when they arose.

68 On 6 March 1995 at the Due Diligence Committee meeting, the defendant advised that PW had a commitment to finish the audit by 10 March and “a number of issues were still outstanding which required supporting papers from the company”. At the same meeting it was noted that although a verbal report had been provided, a written report was required in respect of the Russian contract. A representative of the bank, Mr J Ferreira, was present at this meeting and prepared a note of the discussion that occurred in respect of the Russian contract. That note include the following:

(Ex F: 995)

69 On 7 March 1995 the defendant wrote to the Pacific Due Diligence Committee confirming “the materiality as it should be applied in relation to the due diligence process” and that items which had a greater than A$500,000 value should be regarded as material for the purpose of the Prospectus. He warned that it should not be regarded as “an absolute guide” because items of a lesser amount may require disclosure in relation to “prospects of the corporation” when consideration was given to s 1022 of the Corporations Law (Ex F: 1004).

70 On 9 March 1995 Pacific received an outline of what BBY understood was the proposed brief to it which included the following terms of reference: (1) to review and comment upon Pacific’s existing financial and strategic plans; (2) to consider and provide recommendations on alternative future funding strategy; (3) to review the cash management systems and provide recommendations for improvement; and (4) to consider, comment upon and provide recommendations in respect of the accounting policies particularly with regard to intangible assets (Ex F: 1008-1009).

71 On 10 March 1995 Pacific advised the bank of the key balance sheet ratios for the Group and that “unfortunately” two of the ratios “marginally exceed the bank’s requirements”. The bank was advised that an audit committee and Board meeting had been convened for Monday 13 March 1995 to discuss and approve the Accounts and sought “if possible, confirmation” that the bank considered “the breaches to be minor and technical in nature and that no action will be taken” (Ex F: 1013).

Draft letters of 10/13 March 1995

72 The defendant prepared a letter, containing the audit report, to the directors of Pacific in “Draft-for discussion only” dated 10 March 1995 (Ex F: 1014-1029). There is a further draft dated 13 March 1995 (Ex F: 1034). This letter was considered at the Due Diligence Committee meeting on 3 March 1995. The plaintiffs claim that this letter is fundamental to their cases because it evidences what PW knew and is relied upon as a basis for suggesting what PW should have done in the light of that knowledge.

73 The draft letter of 13 March 1995 included the following:

We set out below matters which we feel should be clearly understood by the directors in signing the accounts. These matters require serious consideration by the directors in discharging their duty in approving the accounts.

1. GOING CONCERN BASIS OF THE ACCOUNTS

The accounts for the half-year ended 31 December 1994 have been prepared on a going concern basis.

We believe that the accounts should include a note which outlines the cash flow situation in Stanilite and states that temporary credit facilities have been extended to the group by its bankers. This note should clearly state the creditors attached to the extended facilities. At 31 December 1994 the group was in breach of borrowing covenants set out in the banking facility.

In signing the accounts the directors acknowledge that there are reasonable grounds to believe that the company will be able to pay its debts as and when they fall due and that the group accounts are properly prepared on a going concern basis.

We suggest the directors seek legal advice on the implications of signing the accounts on a going concern basis in the light of the current cashflow position of Stanilite and the breach of the borrowing covenants.

2. “RUSSIA CONTRACT”

The total revenue recognised on the half-year ended 31 December 1994 on the contract was $12.8 million. The profit contribution for the period was $6.4 million.

The directors should fully appreciate and understand the aggressive revenue recognition, the credit risks and foreign exchange risks associated with the “Russia Contract”.

2.1 Revenue recognition

The earned value basis has been applied on the “Russia Contract”.

As at 31 December 1994, 33.5% of the sales value of stage one of the “Russia Contract” has been taken to revenue. However, due to the aggressive approach in revenue takeup 75% of the profit margin on this stage of the contract has been brought to account.

Only two 1+ 17 Cellswitch Systems representing $1 million of the revenue (related profit $362,000) had been delivered to Novorossiijsk and invoiced as a 31 December 1994. In addition, microwave equipment with sale value $225,000 (related profit $38,000) had been delivered to Novorossiijsk but not as yet invoiced.

Revenue recognition has been particularly aggressive on the following components of the contract:

(a) Revenue on “management effort”

The contract includes the provision of items supplied by third party suppliers. Stanilite receives 20% markup on the cost of these items for “management effort” in determining the requirement and arranging the supply of these items.
The full 20% markup has been taken up on the following systems no portion of which has been ordered from suppliers as at 9 March 1995:

315 The defendants submitted that the plaintiffs’ attempts to establish their case on these accounts through the cross-examination of the defendant failed. Attacks were made on the defendants on two fronts; first, that the revenues from the contracts ought not to have been recognised in the accounts and, second, that Note 7 in the 1995 accounts should have been reflected in the half-year accounts of December 1994. That evidence included the following:

(tr.832)

(tr.831-832)

316 The plaintiffs’ attempts to suggest to the defendant that the provision made in the 31 December 1995 accounts should have been in the 30 June 1995 accounts were met with a firm response by the defendant. He said: “It never, never did we see a need to make the provision of those amounts at 30 June, I want to emphasise that” (tr.849). The defendant went on to explain that the provisions were raised in December 1995: “because of substantial changes in circumstances” between when the 30 June 1995 accounts were signed in September 1995 and when the December 1995 accounts were signed in February or March of 1996 (tr.849).

317 It was suggested to the defendant in cross-examination that the financial position of the Group at 30 June 1995 was such that it would have been unlikely to be capable of performing the Argentinean Contract. The following evidence was given:

(tr.805)

318 The defendant also gave evidence that he believed that the Argentinean Contract was going to be funded out of the proceeds from the contract (tr.833). On the topic of whether the Argentinean Contract was a construction contract the defendant gave the following evidence in cross-examination:

(tr. 817-818)

319 The defendant’s evidence emphasised that by the time the 30 June 1995 Accounts were to be signed in September 1995 the main change was that the Russian Contract had been on foot for six months longer. The optimism that was present at March and May 1995 was tempered by the fact that in the extra time that the contract had been on foot there had not been any further payment received. The evidence does not establish that there were really any other changes. Indeed paragraph 3.268 of the plaintiffs’ submissions seems to recognise this aspect of the matter:

Although Mr Seaton’s knowledge about the Russian contract increased somewhat in the period from 16 March 1995 to September 1995, the increase was not substantial. The only real difference, for example between 16 March 1995 and 3 May 1995 was that he knew for a fact that the securities had not been provided, the EFIC insurance was still conditional and that there were personality and political difficulties between Dr Bolotov and PTT, in addition to the technical difficulties. Although Mr Seaton says that he believed that the EFIC insurance was in force, he had taken no steps to ascertain that that was the case (tr. 838.22-29 and 839). He had no reason to believe that the special undertaking would be enforced. By September 1995, he knew that the NAB had formally and explicitly reiterated the special undertaking (see the letter of 2 August 1995) and that there had been no waiver. Mr Seaton also knew that the only payment ever made was made in March 1995 and amounted to US$204,000 (A$269,000) – tr 837.30-33. The note to the 30 June 1995 accounts articulated what Mr Seaton had long known.

320 I have found that the defendant did not fail in his duty and did not breach his contract by allowing his audit opinion to be included in the Prospectus when the Accounts included profit recognition on the Russian Contract pursuant to AASB 1009 applying the earned value basis. The real questions for decision on this aspect of the plaintiffs’ claim are (1) whether a loss should have been brought to account on the Russian Contract in the 30 June 1995 accounts; and (2) whether the Argentinean Contract profit should have been included in the 1995 accounts. If a loss on the Russian contract should have been brought to account and/or the profit from the Argentinean contract excluded from the accounts, then the defendants owed Pacific a duty not to sign the accounts in the form that they were signed with Note 7.

321 In my view the plaintiffs’ case has insurmountable evidentiary difficulties. There is no expert opinion expressed as to why a competent and diligent auditor should have formed the view that there should have been a foreseeable material loss as at 26 September 1995 when the audit opinion was signed. Certainly there are facts that demonstrate that Techin Trade was a debtor to the tune of $5.7 million but it is not for the Court to conclude on that fact that there was a foreseeable loss. There is also the subsequent decision of the Board to change the accounting policy in respect of the telecommunications contracts but that is not a proper basis for the Court to conclude that the auditors should have concluded that a foreseeable loss should have been brought to account as at 30 June 1995.

322 The plaintiffs made a forensic decision to call no expert opinion on this aspect of the matter, other than that to which I have referred above, and chose to rely upon the cross-examination of the defendant. Having obtained the evidence that not only the defendant but also the company did not foresee a loss at the relevant time, the plaintiffs submitted that the evidence was “not credible”.

323 In support of the claim that the evidence was not credible the plaintiffs relied upon the following passage of what Lord Pearce said in Onassis & Calogeropoulos v Vergottis [1968] 2 Lloyd’s Law Rep 403 at 431:

“Credibility” involves wider problems than mere “demeanour” which is mostly concerned with whether the witness appears to be telling the truth as he now believes it to be. Credibility covers the following problems. First, is the witness a truthful or untruthful person? Secondly, is he, though a truthful person, telling something less than the truth on this issue, or, though an untruthful person, telling the truth on this issue? Thirdly, though he is a truthful person telling the truth as he sees it, did he register the intentions of the conversation correctly and, if so, has his memory correctly retained them? Also, has his recollection been subsequently altered by unconscious bias or wishful thinking or by over much discussion of it with others? Witnesses, especially those who are emotional, who think that they are morally in the right, tend very easily and unconsciously to conjure up a legal right that did not exist. It is a truism, often used in accident cases, that with every day that passes the memory becomes fainter and the imagination becomes more active. For that reason a witness, however honest, rarely persuades a Judge that his present recollection is preferable to that which was taken down in writing immediately after the accident occurred. Therefore, contemporary documents are always of the utmost importance. And lastly, although the honest witness believes he heard or saw this or that, is it so improbable that it is on balance more likely that he was mistaken? On this point it is essential that the balance of probability is put correctly into the scales in weighing the credibility of a witness. And motive is one aspect of probability. All these problems compendiously are entailed when a Judge assesses the credibility of a witness; they are all part of one judicial process. And in the process contemporary documents and admitted or incontrovertible facts and probabilities must play their proper part.

324 With respect to Lord Pearce it is perhaps dangerous to make generalisations about witnesses because they are so different in so many respects. I am not quite sure what Lord Pearce meant when he referred to “emotional” witnesses, but it seems they fell into a category of people who conjure up legal rights when they do not exist. One can well understand the existence of some “emotion” when one’s professional conduct is under attack, however I find it unhelpful to utilise Lord Pearce’s generalisation.

325 The plaintiffs submitted that the defendant allowed his position to compromise his evidence. It was claimed that as a professional under attack he had given self-serving answers in preference to truthful ones. It was submitted this may have occurred because he was in the position of having to defend the indefensible. The matter that was indefensible in this aspect of the plaintiffs’ claim is apparently that no loss was foreseen on the Russian Contract by him or the Company at the relevant time. What the plaintiffs really emphasised from Lord Pearce’s approach was that contemporaneous documents should feature significantly in the assessment of the defendant’s credibility.

326 The defendant referred specifically to the fact that the majority of the expenditure had already been incurred on the Russian Contract and the fact there was equipment on site in Russia to facilitate the construction of the network. One contemporaneous document, Note 7, referred to the directors’ understanding that the approval from the relevant authorities in Russia, a matter that had delayed the performance of the contract, was imminent. Another contemporaneous document was the letter from the directors referring to the uncertainties listed in Note 7 and stating that they had taken reasonable steps to ascertain that the WIP and the trade debts receivable in relation to the Russian Contract would be “realised in full”. The defendant was working with a company that was described in oral evidence and in the contemporaneous documents, as one that was pursuing a strategy of rapid growth. There was evidence of success in this regard in relation to the first Argentinean contract worth $20 million. The defendant gave evidence that the results of the company fluctuated from month to month depending on when contracts came in and contract work was done (tr. 751). These matters together with the optimism of the winning of the Russian Contract running parallel with the approach of a banker that, although it imposed tight reins, was “supportive” were all matters that need to be taken into account in assessing the plaintiffs’ claim that the defendant’s evidence was not credible.

327 The plaintiffs also submitted that the fact that the defendant required Note 7 to be included in the accounts and required the letter from the directors, is evidence supportive of the submission that he really did foresee a loss on the Russian Contract at that time, in contrast to his oral evidence.

328 The defendant’s letters to Pacific do not support the picture that the plaintiffs paint of the defendants’ conduct in this case. The letters present rather the opposite picture of an auditor and then independent accountant monitoring the suggestions made to the company and bringing those suggestions back with the response of management for further consideration of the Board. There is nothing in the 8 December 1995 letter that demonstrates that the defendant really foresaw a loss on the Russian contract at the time he signed the opinion in September 1995.

329 The fact that Note 7 was included in the accounts does not demonstrate to me that the defendant foresaw a loss. It is appropriate to refer once again to the contents of that Note:

Work in progress after deducting progress claims includes $8,702,000 (current) and $14,350,000 (non-current), including attributable profits to date, which relate to a contract dated 11th November 1994 (and as subsequently amended) for the installation of a telecommunications system in Russia with Techin Trade Limited (TTL). In addition, an amount of $5,738,000 is included in current trade debtors in relation to progress claims on the contract.

The Group’s ability to receive payment for work on this contract and the timing of those receipts is dependent on:

(i) the approval of the system by Russian telecommunications authorities and its subsequent roll out by TTL;

(ii) remittance of a contracted proportion of the proceeds from the sale of terminals, collection fee and call revenue by regional operating companies to TTL or directly to the economic entity at the discretion of TTL; and

(iii) availability of US dollars from the Russian Central Bank.

The directors have evaluated the technical and commercial risks associated with this contract. The testing of the system by the authorities is under way and the directors believe that approval of the system is imminent, based on company prepared forecasts in relation to the market in which the systems will operate. The directors consider that the allocation of the assets between current and non-current and recognition of the attributable profit is appropriate, notwithstanding the uncertainties inherent in the matters mentioned in the above paragraph.

To date the economic entity has received $269,000 from TTL in relation to the contract. Ownership of the equipment does not pass until payment has been received in full. Export insurance for 60% of the invoiced amounts has been taken out with Export Finance and Insurance Corporation. In addition, the economic entity holds guarantees and other security estimated by the directors to have to a maximum value of $10 million.

(Ex F: 1982)

330 The rendition of the facts in this Note is not equivalent to the test in AASB 1009 that a “material loss” was foreseeable (cl .20). It may be that one might suspect that a person reading this material might have their doubts as to whether some loss might be foreseeable on the contract but what was required to be brought to account as soon as it was foreseeable was a “material” loss. Similarly the fact that the directors wrote the letter at the defendant’s request does not establish that the defendant foresaw a “material loss” at the time. It may be concluded that the defendant wanted the directors to ensure that the technical and other difficulties that had been experienced would not further impede the performance of the contract having regard to the fact that time had passed with no further payment, but in my view the evidence is not such as to render the defendant’s statement in his oral evidence that neither he nor the Company foresaw the relevant loss, as lacking in credibility.

331 I accept the defendant’s evidence that he and the Company did not foresee a loss at that time. The next question would have been – was that view one that was available to the reasonable and diligent auditor on all the facts as they presented at that time? The plaintiffs’ evidence does not address this question. Mr Shanahan’s evidence, being the only evidence to address this aspect of the matter in only a general way, does not assist. The evidentiary difficulties of the plaintiffs are, as I have said, insurmountable.

332 The same difficulties apply to the claim that the profit on the Argentinean Contract should not have been brought to account. No witness for the plaintiff addressed the details of the contract, the nature of the contract, or the expectation in respect of what a competent and diligent auditor should have done in relation to the profit on this contract in the 30 June 1995 accounts. The only evidence was that of Mr Shanahan referred to earlier in the two paragraphs as extracted. There is certainly nothing in the letter of 8 December 1995 that supports the plaintiffs’ claims that the defendants were negligent or in breach of their contract.

333 The Statement of Works in Attachment I to the Argentinean Contract required Pacific to “design and interface its cellular basestation and switching equipment to the CTI supplied satellite network and will optimise the total system within the characteristics imposed by the use of satellite connections between basestations and switching equipment” (Ex F: 1522). The Contract also included the following:

Stanilite will be responsible for all the wiring and cabling of the cellular equipment. It will be responsible for connecting the interfaces between the satellite and the cellular equipment.

Ancillary equipment such as electrical crimps/lugs, fuses, cable ties, and other consumables needed to support installation of Stanilite equipment will be provided and installed by Stanilite.

If any event or circumstance beyond the control of Stanilite that results in delay or otherwise impacts on the work then Stanilite will provide notification to CTI within 1 day of Stanilite becoming aware of the issue. CTI will commence activity to resolve the issue as soon as practicable. An example of such a situation may be temporarily removing a section of the fence to provide additional space. If a work around cannot be accomplished an exception will be generated by CTI.

(Ex F: 1533)

334 CTI was obliged to provide services to facilitate the Project Completion including making “sites ready and suitable for installations including towers, antenna, cable, empty buildings/shelters on-site” to accommodate the standard equipment, fencing and certain utilities (Ex F: 1508). This of course was the type of work for which the plaintiffs were responsible under the Russian Contract relevant to the question of whether that contract was appropriately categorised as a construction contract within AASB 1009. What was actually required under the Argentinean contract for the plaintiff to “optimise the total system within the characteristics imposed” as required by the Statement of Works was not explained in the evidence by any of the plaintiffs’ witnesses. The design work and the “interface” and “optimising” of the system to the construction work, (the building work including the antennae and towers etc. completed by CTI) seem to me to establish that the contract could reasonably be described, as Mr Robertson did in respect of the Russian Contract, as a contract for “other services relating to the construction work”. The plaintiffs called no evidence to establish that the pre-requisites to the application of the percentage of completion, or earned value method, had not been satisfied in respect of the Argentinean Contract.

335 It was suggested to the defendant in cross-examination that there was a danger of the imposition of heavy penalties under the Argentinean contract if there was default. The defendant agreed there were penalty provisions but resisted any suggestion that the defendants or the Company were concerned in mid-1995 or in September 1995 that such would eventuate (tr. 805). It was also suggested to the defendant that the company’s liquidity problems should have given him cause for concern that the company could perform the Argentinean contract. The Contract was entered into on 27 June 1995, although Pacific anticipated profits being brought to account on the earned value basis in its Schedule of Revenue Accruals prepared in about April/May 1995 (Ex F: 225). The Contract spanned reporting periods and the defendant pointed out that $5 million was received from CTI in July 1995 that was to fund the performance of the contract (tr. 805).

336 The claim as finally propounded was that the provisions in the 31 December 1995 accounts should have been made in the 30 June 1995 accounts. The defendant’s evidence that there were changed circumstances between September 1995 when the 30 June 1995 Accounts were signed and February/March 1996 when the 31 December 1995 accounts were signed is a pertinent observation and one that I accept as reasonable. The change in the accounting policy introduced as a result of the Arthur Andersen report and later review and the bank’s requirements had a very great impact on those latter accounts. The fact that such a step was adopted by the plaintiffs in response to the report and the bank’s requirements is not evidence that the defendants were negligent or in breach of contract.

337 Mr Shanahan relied upon Appendix 1 to his first report of 6 March 2002 as a basis for the general opinions that he expressed in relation to the 30 June 1995 accounts. Appendix 1 is a partial extract of the letter from the defendants to the directors of Pacific dated 8 December 1995. There is nothing in that extract that supports the allegations made in relation to the Argentinean contract. This aspect of the plaintiffs’ claim also has insurmountable difficulties.

338 The plaintiffs’ claims in respect of the 30 June 1995 Accounts Opinion fails.

Order

339 The Amended Summons is dismissed. If the parties are unable to agree on a costs order I will hear argument on a date to be fixed by arrangement with my Associate, but no later than 23 May 2004.

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Last Modified: 01/20/2005

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Citations

Stanilite Pacific Limited (In Liquidation) and Anor v William Henry Brown Seaton and Ors Trading as Price Waterhouse [2004] NSWSC 376

Cases Citing This Decision

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Cases Cited

3

Statutory Material Cited

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Australian Securities and Investments Commission v Rich [2003] NSWSC 85

Astley v AusTrust Ltd [1999] HCA 6

Haines v Bendall [1991] HCA 15

CITATION:	Stanilite Pacific Limited (In Liquidation) & Anor v William Henry Brown Seaton & Ors Trading as Price Waterhouse [2004] NSWSC 376 revised - 14/05/2004
HEARING DATE(S):	13,14,15,16,20,21,22,23 October 2003 and 2,3,4,8,10,11,15,16,17 & 18 December 2003.
JUDGMENT DATE:	12 May 2004
JURISDICTION:	Equity Division Commercial List
JUDGMENT OF:	Bergin J
DECISION:	Amended Summons Dismissed
CATCHWORDS:	[Negligence] - Claims that defendants, auditors, were negligent in (a) consenting to the inclusion of unqualified audit opinion on 31 December 1994 accounts of the plaintiffs in Prospectus on 3 May 1995 - and (b) signing unqualified audit opinion in respect of 30 June 1995 accounts of the plaintiffs - Allegations that the use of earned value method of bringing profit on telecommunications contracts to account was inconisitent with relevant accounting standards - Whether such contracts construction contracts - Whether material loss forseeable. [Contract] - Claims that same conduct amounted to breaches of contract. [Statute] - Claims that same conduct amounted to breach of provisions of Corporations Law in force in 1995.
LEGISLATION CITED:	Corporations Law
CASES CITED:	AWA Ltd v Daniels t/as Deloitte Haskins & Sells (1992) 7 ACSR 759 Daniels & Ors (formerly practising as Deloitte Haskins & Sells & Ors) v Anderson & Ors (1995) 37 NSWLR 438 Mahony v J Kruschich (Demolitions) Pty Ltd & Anor (1985) 156 CLR 522 Onassis & Calogeropoulos v Vergottis [1968] 2 Lloyd's Rep 403 Swiss Bank Corporation v Lloyds Bank Ltd and Ors [1982] AC 584
PARTIES :	Stanilite Pacific Limited (In Liquidation) (First Plaintiff) SL Electronics (NSW) Pty Ltd (In Liquidation) (Second Plaintiff) William Henry Brown Seaton & Ors Trading as Price Waterhouse (Defendants)
FILE NUMBER(S):	SC 50055/01
COUNSEL:	FM Douglas QC, and CE Adamson SC (Plaintiffs) JH Karkar QC, IM Jackman SC and MR Elliott (Defendants)
SOLICITORS:	Deacons (Plaintiffs) Minter Ellison (Defendants)