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Inquiry into the 1 Parliament Street Car-Park Limited Contributory Mortgage

THE VALUATION INFORMATION

The Contributory Mortgage Regulations require that contributors are given a written valuation report on the subject property that is prepared and signed by an independent registered valuer, containing the information set out in the Third Schedule to the Regulations.
The Commission considers that the valuation report dated 27 August 2001 given to contributors was likely to deceive, mislead or confuse with regard to a material particular, namely the value of the subject property. The Commission formed the opinion that the valuation report was likely to deceive, mislead or confuse in two main ways:
1. it did not contain all of the information required by the regulations; and
2. the dollar figure of the value itself was misleading because of the basis upon which it had been calculated.

Required valuation information

The regulations require a valuation report to set out a range of defined values for the subject property. These include (in simplified terms) the latest government valuation, the value of the bare land (the "land value"), the value of any improvements on the land, and the value of the land including any improvements (the "capital value"). For a development mortgage, it is also required to set out the land value minus the cost of removal of any improvements to the land (the "modified land value"), and the capital value of the property after completion of the development.
Obviously it is material for investors to know what the property is worth at the time they invest in it, as well as what it might be worth after the development is completed (which in some cases is some time after their money is due to be repaid). For example, the modified land value is relevant because, if the borrower defaults and the property has to be sold in a mortgagee sale, it may be that the most a buyer will pay is the value of the bare land minus the cost of demolishing a partially completed development.
The regulations also require that the valuer makes a recommendation as to the amount for which the land provides adequate security for a loan on first mortgage. This is material because investors will be taking a proportionately higher risk if the amount of the loan is higher than the recommended amount. In the Commission's view, for many small investors with some experience in mortgage investments, the valuer's mortgage recommendation may be the single most important factor in deciding whether to invest.
The regulations also require a statement by the valuer that the valuation has been prepared for use by intending lenders, and that the valuer has consented to the distribution of the report to intending lenders and has not withdrawn that consent. This is so that investors know that the report has not been prepared for some other purpose that could make it unsuitable for investors to rely on. It also triggers certain liability provisions if the report contains an untrue or misleading statement.

Missing valuation information

The valuation report dated 27 August 2001 given to contributors to the Parliament Street mortgage did not comply with the regulations in that it did not contain the land value, the capital value, the modified land value, or a mortgage recommendation.
The valuer has told the Commission that "the initial valuation" was prepared for Clode in accordance with Clode's instructions, was not intended for contributory mortgage purposes and for that reason did not contain the information required by the Contributory Mortgage Regulations.
The Commission notes however that the valuation report given to contributors, dated 27 August 2001, contains the statements about independence and consent required by the Contributory Mortgage Regulations. The valuer states in the 27 August valuation that he has "acted in an independent manner as provided for under Regulation 5 of the Securities Act (Contributory Mortgage) Regulations 1988". He also states that "the valuation has been prepared for use by intending lenders, we consent to the distribution of the report to the intending lenders and that, as at the date of the valuation report, we have not withdrawn that consent". The Commission considers that these statements indicate that a contributory mortgage was anticipated in the preparation of the 27 August 2001 valuation report.

Misleading valuation

Under section 5(4) of the Securities Act, contributory mortgages are exempt from certain provisions of the Securities Act, including the requirements to have an investment statement and a registered prospectus. However, they are not exempt from the provisions relating to advertisements.
Contributory mortgage offer documents, including the valuation report, are by definition advertisements for the purposes of the Securities Act and the Securities Regulations 1983, which set out requirements for the content of advertisements for offers of securities.
One of the principal requirements is set out in Regulation 8 of the Securities Regulations 1983, which provides that:
"No advertisement shall contain any information, sound, image, or other matter that is likely to deceive, mislead, or confuse with regard to any particular that is material to the offer of securities contained or referred to in the advertisement".
The Commission has formed the opinion that the valuation report given to contributors, dated 27 August 2001, breached Regulation 8 of the Securities Regulations 1983. As well as failing to contain all the required information, the report was also misleading, in the Commission's view, because of the basis upon which the property value was calculated.
The 27 August valuation report stated that the "total market valuation upon completion" was $49,215,500 "including GST if applicable". This figure was set out in an "Executive Summary" at the front of the report, immediately followed by the following statement:
"Please note; the above valuation is a summation of the individual unit values, including goods and services tax, upon completion. No allowance has been made for selling costs, profit and risk or holding costs."
That statement is repeated later in the report, under the heading "Special Conditions".
This means that the valuation is based on what might be termed the "gross realisation" of the property. The valuer has estimated what each of the apartments and car parks might sell for when completed, and added those figures together. He has not deducted any of the costs associated with selling the apartments.
In the Commission's opinion the use of such a valuation in the present context is misleading because a seller will never actually receive the gross value of a property. There are always costs of sale that will be offset against the gross sale price.
The Commission considers that valuation on this basis is misleading even though the basis is clearly disclosed in the report. This is because an investor is unable to determine from the report what the nett value of the property might be. Reports for this property prepared at a later date (as discussed further below) indicate that the nett value of the property is 20% - 25% lower than the gross value. The Commission considers this to be a material difference that should have been disclosed to contributors.
Further, even though the basis on which the valuation was prepared is spelt out, the expectation of prudent but non-expert investors that the valuation would reflect what they could expect if the property had to be sold creates a very real risk that some would not appreciate the significance, let alone the extent, of the difference.
Also, it appears that the borrower did not intend to repay the contributory mortgage by selling the apartments and car parks separately. It intended to rent them out and refinance the mortgage with a mainstream lender. The Commission considers that the report given to contributors should have contained a valuation that reflected the borrower's actual intentions, showing a projection of its value measured by its income earning capacity, which is a common mode of valuing investment properties.
MFL has submitted that a broker should not be responsible for a misleading method of valuation. Submissions on behalf of MFL state:
"While our client has been prepared to accept responsibility, subject to materiality, where the valuation does not comply to the letter with the statutory requirements, we believe it is placing an unreasonable onus on the broker to make an assessment of a valuation that it is not at law required to do, nor is it qualified to do so. That role must be fulfilled by the valuer. In our submission, the current form of the Commission's report would suggest that the potential liability of a broker is much wider than the industry would expect."
In the Commission's view it is clear under the law, particularly Regulation 8 of the Securities Regulations 1983, that the broker is obliged to ensure that nothing in an advertisement, including valuation information, is likely to deceive, mislead or confuse investors about any matter that is material to the offer. This obligation is fundamental to the operation of the securities laws and applies to issuers of all types of securities, including contributory mortgage brokers. It applies regardless of whether the information is provided by a third party "expert". It will require the broker to do more than simply "tick the boxes" to check that the prescribed information is included. Accordingly, the Commission is unable to accept MFL's submissions that a broker should not be responsible for a misleading valuation report.

History of the valuation reports

Several valuation reports have been prepared by BBJ for this property. As noted above, it seems that all contributors were given a copy of the report dated 27 August 2001 that valued the property at $49,215,500. Those who received offer documents after 5 October 2001 or thereabouts were also informed that the property had been revalued upwards to $52,036,500 because the borrower had reconfigured the floor space to fit in more apartments. Those investors were not given a copy of the amended valuation, which we understand was dated 27 September 2001. Earlier investors were not informed of the change.
It is clear from the evidence that MFL was aware all along that the valuation report did not comply with the regulations.
It was a condition of the loan offer made by MFL to the borrower that it obtain a valuation from MGC that complied with the regulations. MFL attached a copy of the Third Schedule to the regulations to the loan offer. The evidence indicates that the borrower did not satisfy that condition before MM began marketing the offer. Instead, SRL agreed that the borrower could provide a BBJ valuation that Clode already had "on file". It is not clear whether the valuation report on Clode's file was the same report given to investors, dated 27 August 2001. However, it is clear that the report given to investors did not satisfy the conditions of the loan offer, and did not comply with the Contributory Mortgage Regulations.
Davidson told the Commission that he agreed to use the 27 August valuation report, even though he knew it did not comply in certain respects, because he did not believe that the deficiencies would lower the value of the property. MFL appeared to be under the impression that it could rectify the breach of the regulations by sending contributors a copy of a compliant valuation at a later date. MFL continued to press the borrower on the matter. There is evidence that Clode did instruct BBJ in writing to produce a further report that did comply with the regulations. There is also evidence from the valuer that Clode subsequently qualified this instruction verbally.
In the meantime a review of the BBJ valuation was undertaken by MGC. The review, called a "check valuation" by the parties, is dated 8 October 2001 and addressed to Mortgage Financier Nominees Ltd C/- SRL. This review noted that several items of information required by the regulations were missing from the BBJ report, and also queried the basis of the valuation, as follows:
"It is evident that on completion, if the units are to be sold, then allowance would need to be made for costs to be incurred including selling and legal costs, interest during the sale period, holding costs and an allowance for profit and risk. Alternatively, if the building was to be retained for rental purposes i.e. 221 rental units, then its value as a single holding would more likely be calculated adopting the investment approach, allowing for vacancies, holding costs, management costs, etc (as well as maintenance) and an appropriate capitalisation rate adopted based on comparable development.
The instructions to Barratt Boyes Jefferies Ltd, apparently required neither of these calculations to be undertaken, the request apparently being solely for a total, including GST, of the individual values of the units, and was subject to separate titles being issued. Presumably the mortgages would be registered against each title. However the potential gross income of the 221 apartments was also provided.
It is apparent however, even though Barratt Boyes Jefferies Ltd were not requested to value on such a basis, that the value would be significantly less than the combined value of apartments of $52,036,500 including parking if considered as a single entity.
We draw this to your attention for consideration when making any mortgage advance to the development. This could impact on the gross realisation by a factor of 20% - 25%."
On 8 February 2002, MFL received a copy of what it considered to be a compliant valuation (except for a minor typographical error which meant that the value expressed in words differed from the value expressed in figures). In this report, BBJ allowed for costs of sale. It also included a separate calculation of the value based on the building being retained as a rental property. Both methods of valuation produced a value of approximately $40 million, some $12 million or 23% less than the value previously advised to contributors. This report also included a mortgage recommendation of $26,600,000, slightly less than the amount of the loan the borrower was seeking to raise.
Davidson has told the Commission that MFL intended to have the typographical error amended, send the 8 February valuation to all contributors, reduce the amount of the loan to $26,600,000, and offer existing contributors the chance to withdraw their investment. Essentially, this would have amounted to making a new offer.
As the first step in this process, Davidson says that he asked Clode to ask BBJ to amend the typographical error. Davidson has told the Commission that Clode did not do so, but instead instructed BBJ to revert to the "gross realisation" method of valuation which would show a value of $52 million rather than $40 million. The valuer, Amesbury, has also told the Commission that Clode verbally countermanded his previous written instructions to produce a compliant valuation and instructed him to revert to the gross realisation method. We note that Clode has subsequently told the Commission verbally that he instructed BBJ to comply with the regulations. The statements of Amesbury and Clode are in conflict on this point. It is not necessary for the Commission to resolve that conflict.

Investors not informed

While MFL was apparently waiting for a compliant valuation report, the Commission made orders banning all advertising of the Parliament Street mortgage, and commenced this inquiry shortly thereafter.
Despite MFL's apparent attempts to obtain a compliant valuation, investors were never fully or properly informed about the value of the property. MFL was aware from the outset that the 27 August valuation report given to investors did not comply with the regulations. It ought to have also been aware, after receiving the MGC review, that the valuation given to investors was prepared on a basis that was likely to mislead investors. The borrower and its owner, Clode, were also aware the report did not comply. The MGC review was sent to SRL for the attention of an SRL employee. SRL was therefore on notice from 8 October 2001 that the valuation information given to investors was non-compliant and misleading. As SRL refers to itself as the "agent" of MM in this matter, the Commission also concludes that MM knew or ought to have known about the deficiencies in the valuation information.
Despite their knowledge of these breaches of the law, there is no evidence to indicate that any of these parties took any steps to stop the offer or to inform contributors about the non-compliant valuation. MFL may have intended to do so, but did not do so. MM continued to market the offer and to receive contributions, SRL made no attempt to withdraw the First Step money it had contributed, and MFL continued to take in contributions and to pay out funds to the borrower in accordance with six drawdown requests.

THE PROMISSORY NOTE

One of the key documents in the Commission's inquiry is a document referred to by the parties as "the promissory note". A copy of the promissory note is at Appendix A. It is headed "Promissory Note" and expressed to be from MM to Mortgage Financier Nominees Limited. It is signed by Somers-Edgar and dated 28 September 2001. The text of the note reads as follows:
"We the undersign [sic] promise to raise funds to the quantum amount of $27,000,000.00. Such funds represent the full subscription to the loan of $27,000,000.00 to be incrementally advanced to 1 Parliament Street Limited [sic].
We undertake to make good our promise incrementally by or before Friday 29 March 2002."
It seems clear that the promissory note came into existence because the full amount of the loan had not been raised in time for the first instalment to be paid out to the borrower.
The parties agree that Davidson of MFL asked that Somers-Edgar sign the promissory note. Davidson has told the Commission that he requested the promissory note because he understood that the law required the full amount of the loan to be raised before the building project could commence. He said that he regarded the promissory note as being "as good as cash", and that on faith of the promissory note MFL was able to begin advancing funds to the borrower.
MM, SRL and Somers-Edgar agree that Somers-Edgar signed the promissory note to enable the project to commence. They have made the following submissions concerning the circumstances in which the promissory note was provided :
"DSE [Doug Somers-Edgar] was asked to sign the PN [promissory note] by Al Scott [of Money Managers]. There was no pressure on DSE to sign the PN, it was signed simply so that the development could get underway.
This point is important. It is not correct to draw any inference that because the PN was signed, MM anticipated difficulties in being able to raise the full amount of the funds for PSM [the Parliament Street mortgage]. Quite the opposite is the case.
DSE had no concerns at all about signing the PN because he knew at the time of signing it that MM would have no difficulty whatsoever in raising the funds. DSE knew that MM could raise the funds, - in particular from maturing contributory mortgages. When Al Scott gave DSE the PN to sign, he also provided DSE with statistics about the level of funds MM would be receiving from maturing mortgages...
In these terms, the PN is equivalent to cash in the hands of MFL and should be regarded as such by the Commission."
Whatever Somers-Edgar's views, the documentary evidence received by the Commission indicates that MM was having difficulty raising the funds and that at least part of the purpose of the promissory note was to avoid canceling the offer and returning funds already subscribed. For example, the following message was sent by e-mail to MM branches on 25 September, 3 days before the promissory note was signed:
"Parliament Street mortgage
With just 10 days to go before Parliament Street mortgage is due to be completed, we note there is $11 million booked and $6.1 million banked. This leaves us with the following options:
Before we make the final decision, we need to get some feedback from advisers. Given previous calls for CMs and the purported demand that existed for them at the Fiji RO conference, is the problem just with Parliament Street? Has the debacle in the US been a factor in the slow bookings? Is there a perception this is another Metropolis? Are CMs finally getting a reputation for not repaying on time? Is the lack of a Lloyds of London insurance been a factor? How much damage has the non-repayment of Downtown Medical etc been a factor?
Once we receive your feedback, we will re-evaluate the situation and make a decision.
Regards, Alasdair Scott."
The following e-mail was sent to MM branches two days later, on 27 September:
"Thanks for your feedback over the Parliament St mortgage. To summarise, the consensus was to extend the mortgage. While it was not mentioned in my first email, an extension would require a Promissory Note provided by Money Managers effectively underwriting the remainder of the mortgage. We have agreed to the extension until 1 March 2002, but realistically expect the full amount to be raised by early December...
Obviously a Promissory Note of this magnitude is a significant commitment. We appreciate the same commitment by many ROs and advisers that they will continue to market this investment to clients and prospects.
Alasdair Scott"
Whatever the reasons for the promissory note or the parties' intentions in making it, the parties appear to agree on its legal effect. Davidson and MFL believed that it constituted an unconditional promise to raise $27 million dollars for the loan and to pay any shortfall that had not been raised on or before 29 March 2002.
The submissions of MM, SRL and Somers-Edgar support that interpretation. They say:
"By the PN, MM has undertaken '...to make good the promise' by 27 [sic] March 2002. The only way MM can meet this undertaking is to pay any shortfall (from not having raised the full $27m) to Mortgage Financier Nominees Limited on or before 27 March 2002.
It is accordingly an unconditional promise to pay this shortfall....
To interpret the PN otherwise is to violate the clear meaning of the words in the PN".

Effect of the promissory note

It is neither appropriate nor necessary for the Commission to comment on the contractual effect or legal enforceability of the promissory note.
For the purposes of the securities laws however, the Commission does not consider that the promissory note is "equivalent to cash in the hands of MFL" as submitted by MM. The Contributory Mortgage Regulations prohibit funds being paid to a borrower unless contributions have been made by contributors to the particular mortgage that equal the amount of the principal sum of the mortgage. Those contributions must be held in the broker's trust account or invested on behalf of contributors. Those contributions must also be sufficient to complete the development (Regulation 21). The Commission considers that Regulation 21 requires that all the money must be in the broker's trust account before any can be paid out to the borrower. The reason for this is fairly clear - if the broker is unable to raise the total amount of the loan, it will be unable to return contributions in full if it has allowed the borrower to spend some of the money.
In this case, contributions equaling $27 million had not at any time been held in MFL's trust account, or invested by MFL on behalf of contributors, before the Commission made its orders. Sufficient funds to complete the development had never been held. Despite this, MFL paid out some $8 million to the borrower, or for its benefit, on 8 October 2001. The Commission has formed the opinion that in doing so MFL breached the regulations and thereby placed contributors' funds at risk. For the purposes of the Contributory Mortgage Regulations, the Commission does not consider that a promise to top up any shortfall at a later date is equivalent to "money in the bank" at the time of payment to the borrower.
We have referred above to the submissions of MM, SRL and Somers-Edgar that the promissory note was an unconditional promise to pay any shortfall on or before 29 March 2002. Those parties also submitted that this matter should be resolved by MFL reverting to contributors with compliant offer documents and an explanatory letter, and offering them the option to withdraw their contribution.
In light of those submissions, the Commission wrote to MM's solicitors on 22 March 2002 as follows:
"Would you please confirm that the effect of these submissions is that Money Managers will make good any shortfall in the $27 million remaining after contributors have decided whether or not to withdraw their investment. In other words, please confirm that Money Managers agrees that its obligations under the promissory note will extend beyond 29 March until such time as contributors have decided whether or not to withdraw."
On 26 March we received the following reply:
"...in order to assist the Commission and a speedy resolution of this matter, MM is prepared to confirm that it will '...make good any shortfall in the $27 million remaining after contributors have decided whether or not to withdraw their investment' on the following terms:
We replied that "the Commission will not enter into any discussion, or consider any proposals, which would imply a constraint on the Commission's powers to properly address the issues raised in its inquiry". MM solicitors assured us in reply that it was not MM's intention to imply any such constraints. A copy of this exchange of correspondence is at Appendix B.

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