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October 2007 Edition ---- to page back through Previous Editions click here

We now focus on the roles of the Institute of Chartered Accountants of New Zealand and the NZ Securities Commission in deterring action against the vendors of Feltex Carpets Ltd to the New Zealand public in 2004. This issue symbolises the profession and that is why we concentrate on it.

We have somewhat belatedly discovered unwarranted praise for the Credit Suisse group on page 3 of the Annual Report of the ICANZ for its 2006 year. (well it is after the Contents list and page 3 as far as Adobe is concerned but officially it seems the pages haven't started) The page features a photo of one Niven Robinson, a member in the Institute, taken in Zurich, international headquarters of Credit Suisse. There was a short biographical piece from Mr Robinson, presumably New Zealand born and educated, explaining how he had joined the firm in London and had later taken a transfer to Zurich where he had become a Vice-President. Although ostensibly this page was to just how far one could go with the Institute's qualification, we say that it was far more designed to unjustifiably enhance the reputation of Credit Suisse to the accounting profession following controversy over the sale of the marginally profitable or unprofitable Feltex Carpets Limited to New Zealand investors in 2004 for $250m by an off-shoot of CS. We say that if they were going to print this picture and biographical note it should be clearly marked as being an indication of how deep a commerce professional can fall into the dens of corruption if one does not take the greatest of care, be they well educated or otherwise.

The 2007 Annual report of the Institute contains biographical notes and pictures of three Institute members about page 3 but if you go back to their 2005 Annual Report there is no such mini-feature. We expect that the idea was conceived and prearranged by Credit Suisse then somehow sold to or forced upon the Institute.

The Institute has had until recently David Jackson on its governing board. Mr Jackson was for some time an audit partner of Ernst and Young and has then become a Securities Commission member and an Institute office holder. This is a rather similar path to that of Elizabeth Hickey who audited the large zero coupon bond parcels held by the Bank of New Zealand in 1990 and went to incredible lengths to try to excuse not applying the YTM method to allocating the bond income amongst the years the bonds cover. She sat on the Securities Commission in 1993 while they ruled it was just mistakes and misjudgments and there was no evidence of misconduct on her behalf. That Commission could not recognise misconduct no matter how many times it fell over it.

Mr Jackson attended six out of seven Institute board meetings in the 2006 financial year and four out of seven for the 2007 year. The 2007 report did not indicate that he was gone or going but he seems to have gone nevertheless. We think he might have been behind the page highlighting Mr Robertson.

But the 2006 Annual Report of the Institute of Chartered Accountants of NZ is related to the Feltex saga in other ways as well. It reports that John Hagen was made a Life Member of the Institute at its annual meeting in late 2005. He was also appointed to the Appeals Committee of the Institute at that time. Mr Hagen is a past chairman of the Institute/Society but does not seem to be on their committees or boards immediately prior to 2006. One thinks life membership is normally awarded when the member goes out to pasture. Also it was known that Mr Hagen appeared as an expert witness for the defence in the 2001 High Court case Hedley v Kiwi. In paragraph 226 of the judgement it is said that "he [Mr Hagen] said that EY's analysis showed that, without the differential, the Tui shareholders were projected to be approximately 141 c per kilogram of milk ahead of their stand-alone position and even after the differential, approximately 90c ahead." This quote was made in the context of demonstrating that the Tui shareholders stood to do very well out of the merger. But it was not milk that the cents referred to but milksolids which constitute about 10% of milk by weight, and it was not per kilogram of milksolids but per 19 kilograms of milksolids, supplied at the rate of one kilogram per year for the next 19 years. In dairy farmer speak sometimes or often "per kilogram" means "per kilogram of long term annual production" but it is easy for anyone including farmer/shareholders to confuse the two concepts. Nowhere in the judgement or the EY report was it made clear that this was a kilogram of long term annual production of milksolids and we say that many shareholders would have voted for the merger just in case the 90cents applied to each and every kilogram of milk solids supplied as an official interpretation would indicate. We say that Mr Hagen had a clear duty to say exactly what he meant by a kilogram of milk and this failure left the whole case invalid. He would have had the opportunity to correct any mis-stated in the judgement before it was released. We believe he has deliberately gone along with this method of misleading shareholders which had been used so that they voted for the merger on terms which were more favourable to the other company. One this basis we ridiculed Mr Hagen's life membership appointment in our Dec 2006 edition.

Just before receiving his life membership, on 20 October 2005 Mr Hagen was appointed to the board of the ailing Feltex Carpets Ltd. With many years as chairman of the Accounting Standards Review Board one would think that he would be a genius at ensuring that all standards were complied with. But it has been at the start of the 1996 calendar year that the Securities Commission believes that the company has been negligent in this area. That was enough time for him to get to grips with the company's accounting responsibilities. If it is found that the directors were entitled to rely on the word of contractors that everything was being complied with them presumably the contractors are liable.

Mr Hagen replaced Joan Withers on the Feltex board. Ms Withers apparently left to become Chief Executive of the Fairfax newspaper group. One can't really expect these newpapers to be harsh on the Feltex IPO no matter how much it is deserved.

The group seems to have assigned one Marta Steeman to handle Feltex issues writing for either the Press or the Dominion Post. Ms Steeman of course reported in Nov 2005 that New Zealands "exports per capita were almost half that of Australia and 2 1/21/2me less that the USA. But her paper refuses to publish a correction ie that the country's exports per capita are 25% higher than Australia and 75% higher than the United States. It goes on printing arguments that the country's currency is valued too high and did not seem to notice the rising price of dairy exports.

Well the Securities Commission have released a second report on this failed company previously known as Feltex carpets Ltd. It is available from here.

The Commission put out a one page report on the Feltex Prospectus on 25 August 2006 whish said that there was nothing wrong with the prospectus. This report repeats that conclusion and elaborates a little but does not refer to the previous report. We are most critical of the elaboration and are about to set this out.

But first let us say that the new report focuses on the company's failure to advise the breaching of its bank overdraft arrangement back in late 2005 and its failure to properly report its debt structure about that time. The auditors Ernst and Young are accused of having a hand in this. Hopefully it will prompt a total review of these auditors involvement in the whole sage and get them forking out for the whole of the losses. Mr Gordon Fulton will be before the Professional Conduct Committee again. Whether they will feel obliged to take any action this time we will have to wait and see. The same wet bus ticket is probably still be on hand for the occasion.

The Commission again fails to declare that its member David Jackson was an Auckland audit partner of Ernst and Young at the time of the alleged audit inaccuracies. We think such declarations are standard practise except for the Commission. They will say he took no part in deliberations. They would probably be reluctant to dob in their mate nevertheless. There could easily be other Commission members with Feltex connections leaving very few members to decide.

We thought the report might have focused on Feltex declining offers to buy the company or its assets which would have left shareholders a little in pocket. But not so. The Commission does not say that there are any more reports coming up. It seems likely to us that the share value was exhausted by delaying action so that there would be no fighting fund.

Our main concern is with paragraphs 61 and 62 of the report which is about the Feltex IPO prospectus. 61(a) is about the assumption of a 1% market growth. Well that seems a reasonable assumption for the long term of the market but not necessarily for the coming year. The market size no doubt sometimes declines in the short term. The prospectus was dated 4 May and the year being projected started in that July. There would be plenty of relevant building permit and economic statistics available which would have given a better guide. This assumption is rough as guts and the Commission should have so said.

To further illustrate this consider the graph of Australian Carpet Market size on page 37 (adobe 39) of the prospectus. Immediately above the graph it is stated that of the 10 years spanned in the graph the compound average growth rate has been 1.7. We agree that this is the case if you take 44687 as the starting size and 53076 as the end size. The trouble with such an exercise is that it only takes into account the end points and these of course can be most atypical. It can be seen that 1993 which starts the series has the lowest sales by far. If 1994 is used as the starting year the annual growth for the 9 years is 0.7% making the 1% adopted for the projection quite optimistic. 1993 is the least significant of the years, representing a bygone era to some extent. The statement that 1% market growth is conservative is wrong and the auditors had a clear responsibility to challenge it and mention this in their report if Feltex would not make adjustments. It is the average rate over the past 10 years as the Securities Commission states in its Paragraph 61 but exactly 10 years does not produce an acceptable average. The New Zealand graph shows growth of 3.2% calculating the same way as Feltex have for Australia because NZ has a boom figure for 2003.

The fairest approach is probably least square analysis which takes all the years into account. Our calculations show that on this basis gives compound growth of 0.76% for Australia and 0.87% for the two countries combined. We say the 1% is not conservative but over optimistic.

More relevant is the ridiculous projection of a 1% increase in market share. All market participants would have sophisticated strategies aimed at getting a similar increase in market share but the sum total of all their efforts would of course have been zero. In Paragraph 62 the Commissions says that they received information and explanations supporting the 1% share assumption. Well may be but they had to have good reasons to believe that Feltex's strategies were believed by Feltex with good reason to be better than those of other participants. We believe that they did not and this assumption is without foundation and fraudulent. All participants have lots of brains and creative flair and it is naive to assume that yours are superior in such circumstances. Import tariffs in Australia were reducing and it would be fair to assume that importers would have an advantage in improving share and if so others will on average suffer a reduction. There is no place for using marketing targets as assumptions for making prospectus projections. We suspect that the Strategic Plan which the Commission refers to in paragraph 63 is an optimistic plan designed to spur along the sales force. It is what should happen if everything planned went right. We have no complaint about optimism in such plan but in the prospectus realism was claimed to dominate and should do so.

We believe a 1% increase in market share means 1% of total market sales will be achieved by the company over and above the percentage it achieved the previous year. (eg market share will increase from 5% to 6% or 10% to 11% etc depending upon what the starting share was). However the forecast and projected revenue of the company seems barely consistent with this, especially as one would expect the revenue to contain an inflation allowance. Changes in revenue, actual, forecast and projected 2003 to 2005 are -2.5 %, +6.7%, and +3.8%. A possible explanation is that carpet prices are predicted to fall which is consistent with increased imports. .

The other factor that Feltex had to consider is that sales support of the company by the vendors would likely come to an end. Credit Suisse F B had used Feltex carpets in the refurbishment of their Maddison Avenue offices. We expect that there would have been much more support by this massive financial institution both directly and indirectly such as making laying of Feltex carpets a condition of loans for buildings etc. The Securities Commission seems not to have considered this aspect. It is quite likely that Credit Suisse dressed up Feltex for sale by this method. Once they have the sale proceeds that's it, although it seems that they waited until the first dividend was paid to the new owners. The dropping of ownership ties is always a critical factor which needs discussion in a prospectus. It appears that there were none.

There is no excuse for adopting "no change" scenarios. Change is the one certainty so they say.

The enormity of the 1% market share assumption should not be underestimated. The prospectus was very specific about the company's share of manufactured product in its prime market area of Australasia. Feltex was the second biggest market participant, but there were several other significant players and it seems it made 25-27% of all carpet made in the region.. If market share was 25% the 1% assumption means 4% more company sales and with excess capacity it seems that a large portion of this extra revenue ends up in profit. Perhaps it increased projected profit by 50%.

But how much manufacturing is done has little to do with market share. The prospectus acknowledges that it has considerable competition from imports but does not seem to say what portion of its market was being supplied by imports. It went on somewhat about tariff reductions and the risk or inevitability of further competition from imports but somehow they still declared a 1% increase in market share to be a realistic assumption. A 1% increase in market share might be equivalent to a 10% increase in its own sales which is ridiculous and we say that the Securities Commission knows it.

Readers of the prospectus should have been able to decipher this for themselves and no doubt many did and tossed the application form. But they were falsely told that the projections of revenue and profit were realistic and readers were entitled to believe that this was so. And of course they or their advisers (official and otherwise) would have read the audit report and the auditors indicated they had only one reason for not expressing an opinion on whether the projections would be achieved. That had nothing to do with the assumed growth in market share upon which the projections were based, so these readers have decided that the auditors were in a better position to judge the matter and have subscribed.

The assumptions have to be realistic. We say this one is not and has likely caused the collapse. Once they found substandard work the Commission should have reviewed everything. Its claims that Feltex's assumptions were realistic is totally disgusting.

We have had a good response last month from people interested in this failed company previously called Feltex Carpets Limited and now renamed Exftx Ltd.

We wish however to restate our argument that the auditors of Feltex's 2004 IPO prospectus have misled the public into subscribing for these shares per medium of the following paragraph at the bottom of their audit report.

"Actual results are likely to be different from the forecast and projected financial information since anticipated events frequently do not occur as expected and the variation could be material. Accordingly we express no opinion as to whether the forecasts for the year ending 30 June 2004 and projections for the year ending 30 June 2005 will be achieved. ".

They say the information in the first sentence is the reason, presumably the only reason, why they do not express an opinion as to the projections being achieved.

They hence imply that they had investigated and considered the reasonableness of the assumptions which underlie the projections and found all to be satisfactory. If this were not so the fact that it is not so would be a far more relevant reason why they were not expressing the opinion. The readers of this statement at the time of the offer have therefore justifiably concluded that all was well with the projections, and the assumptions upon which they are based, because of the reason the auditors have given for not expressing the opinion.

But the auditors have subsequently revealed that they intended to express no opinion as to the reasonableness of the projections, presumably because they had not done the work and come to a conclusion on the matter. The sole reason they gave in their audit report for not expressing the opinion was not a sole reason and not even the most relevant reason.

We accept that that paragraph was probably not designed specifically for the Feltex audit report. We believe that sometime previously the second sentence without the word "accordingly" was a standard inclusion in such audit reports. But we suspect that some in the business community thought (or at least hinted) that such a disclaimer was too off-putting. Perhaps it would be fair for the reports to say that auditors not investigating or reporting on the reasonableness of forecasts and projections was current standard practice. But giving this basic reason for not expressing the opinion referred to, we say is totally unacceptable and has cost many or most readers many thousands of dollars. It could be that some well meaning clerk thought the two sentences should be linked and so linked them as the Institute have suggested. We think it more likely that such a story has been hatched to help explain away the link. Auditors have a duty to closely scrutinise their report to see that every sentence is accurate and not misleading. Where a company which has raised funds employing this audit message is moderately profitable or better probably no one will complain but when virtually every shareholder incurs a loss the auditors should have to carry the can.

. Let us now consider the meaning of the first sentence. We have previously described it as pointing out that future happenings are invariably uncertain. On reflection we concede that the message is a little bit wider than this and is drawing attention to the fact that forecasting and projecting is not a very reliable process. We cannot disagree with that, but in order to decide whether to subscribe readers have got to decide for themselves how profitable they think the company will be, and the opinions of others, particularly those with inside knowledge could be very helpful. The sentence is referring to share issues in general but readers will have advances beyond that point. They are prepared to invest in such share issues but wish to avoid duds. That is why they read this particular prospectus or listened to people who had done so.

While forecasting and projecting might not be a very precise science it is necessarily an indispensable one in today's and most other worlds. It has to be done so a fair price for shares to be reached with some degree of certainty. Accountants are generally well placed to do a good job of it. It is a pity that auditors run away from the task when they have already had to familiarise themselves of the assumptions which a company has adopted to produce the projections. We think it will not be long before they do directly express an opinion on the validity of forecasts and projections. And when this happens we think Ernst and Young will be keen to do the work despite what they have said in this audit report paragraph.

The second sentence says that the message of the first sentence is the reason why they, Ernst and Young are not expressing an opinion on whether these particular forecasts and projections will be achieved. The presumption is that it is the only reason and hence they have done all the checks necessary to express an opinion an found nothing untoward. Otherwise they would have said that they never express an opinion on whether any forecasts or projections would be achieved. But the message is that for the Feltex forecasts and projections they are down to just one reason for not expressing an opinion and it is an insurmountable one.

What is wrong with what they have said? Well they have not contracted to express such an opinion. The regulations tend to assume that the auditors will not be giving such an opinion and we not aware of any auditors having done so in similar situations. So the call was not really theirs to make. Giving a negative such opinion would presumably have been a breach of contract. This is not the impression that the paragraph gives. It is misleading. More importantly they have given the impression that their reason as described in the first sentence was all that was stopping them from expressing an opinion. While they don't admit that this is what they imply they admit we think that it is not so, and they had not come to an opinion as to the reasonableness of assumptions upon which the forecasts and projections are based.

The Shareholders Assn and the Gavigan group readily criticise the Feltex directors but seem too scared to criticise the auditors for giving this one insurmountable reason for why they did not express an opinion on the projections when their were other more relevant reasons. The auditors should be the first port of call for these groups.

Interestingly the Shareholders Assn is vowing to use all votes which come its way to try to unseat the 2004 Feltex directors from all company boards. This would include Ms Withers from the Auckland International Airport board were she appears to have earned $92,000 for the last year.

But they are reluctant to discuss what was done wrong. We suggest sales support for Feltex by the vendors of the company should have been investigated and it should have been assumed that it would come to a halt soon after the issue was completed. The 1% increase in market share which was allowed for had no justification. This makes for about a 3% increase in their sale. The 1% increase in the market size might be what can be expected on average but it moves in fits and starts. Inadequate working capital had been allowed for with the vendors wanting to get away with as much funds as possible.

We call on the liquidators to allow us and anyone else access to the shareholders register so that more options can be put to the shareholders. That is an obligation they are not complying with. .

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