March 17, 2015
1MDB is in financial distress: The Evidence is Clear for All to see, only Some don’t
by A H Manaf@www.themalaysianinsider.com
In November 2014, I penned an article calling for the Auditor-General to conduct a public audit of 1MDB, highlighting the warning signs and “alarm bells” which alert us to the case for investigation.
Since then, events have unfolded rapidly and I wish to update my opinion based on subsequent reports that have come to light.
1. 1MDB took up a US$1 billion loan in October 2014 (reported in Reuters IFR). This was reportedly a one-year bullet loan with repayment due in full in September 2015 – we do not know the use of proceeds, assuming they were not utilised to reduce existing debt, the company has now incurred a substantial addition of RM3.7 billion in short-term liabilities (in this case due in six months) to its previous debt picture of RM42 billion as at March 2014.
2. Repayment of an existing RM2 billion bridging loan was postponed from November to December and finally January 2015 culminating in reports that the loan was settled by businessman T. Ananda Krishnan.
Confusing statements have been issued as to the source of the loan repayment. However, there are strong indications in the FY14 accounts as to how management planned to repay this loan.
As explained in the notes to the accounts (pg 170), the RM2 billion bridging loan is to be repaid with either proceeds from a proposed IPO or from an equity commitment by Tanjung. The latter is described as “a Subscription Agreement with Tanjung under which Tanjung agreed to subscribe for equity in PIH of up to RM2.0 billion on the occurrence of certain events… which proceeds shall be used solely for the repayment or prepayment by PIH for any amount owing under the RM5.5 billion loan facility”. As we know, the IPO slated for calendar year 2014 never materialised.
3. Confirmed reports that the government provided a “standby credit” of RM950 million of which more than two-thirds have been drawn in the short duration of two weeks following the granting of this credit.
I do not distinguish between “standby credit” and “loan” when a substantial proportion has been immediately taken up. In view of the haste with which the credit was approved and subsequently disbursed it would be more appropriately defined as an “emergency state-funded loan”.
4. Surprisingly candid statements by Finance Ministry officials which constitute a public admission of 1MDB’s precarious financial position: Second Finance Minister Datuk Seri Ahmad Husni Hanadzlah described the company’s finances and “gearing ratio” as “unsustainable” necessitating “an exercise to rationalise and consolidate its assets”. In other words, 1MDB’s excessive debt levels compel the sale of assets to service and repay these debts.
5. Reports that 1MDB is unable to proceed with the 3B power project. More recently, the MOF refers to the company’s intentions to “transfer the project” and other reports indicate TNB will step in as a partner.
6. The sudden resignation of 1MDBs CEO whose replacement, Arul Kanda, announced stark changes in business direction under the guise of “strategic financial review” involving the sale of assets, including “land assets which may be sold outright or partly sold through joint ventures”.
What is their role in 1MDB?
In simple terms, 1MDB’s proposal to “monetise” assets means it is embarking on the sale and liquidation of company assets, Husni’s subsequent announcement that they expect RM26bn of debt to be settled through “monetising” land banks and future property earnings indicates the asset sale will be extensive.
All of the above point to a clear picture – what we are witnessing here is a company in acute “financial distress” suffering from unsustainable levels of “corporate debt overhang”.
Financial distress is implicated by the company’s inability to meets its financial obligation in a timely manner, in the case of 1MDB a sovereign entity it appears to only meet its minimum obligations with assistance from i. government-funded emergency loans ii. funds extended by a third-party whose legal obligations are referred to in the notes to the accounts.
The reported problems with the 3B project are classic symptoms of a company in financial distress – it is in the unenviable position of having to reject lucrative investment proposals because i. its extensive debt levels render it unable to raise additional funding ii. a substantial proportion of its current revenues and cash flow goes to servicing existing debt.
As reported, 1MDB has had to call off a RM8.4 billion sukuk financing earmarked for the 3B project (Reuters).
“Corporate debt overhang” often leads to a vicious downward spiral. In 1MDB’s particular case, the loss of 3B has serious repercussions on its short-term financial position, too, because its debt reduction proposal is based on the IPO of its energy subsidiary Edra (claimed by the MOF to be slated for June or July 2015) which presumably would be significantly enhanced by the inclusion of a lucrative new power project.
Other symptoms of “corporate debt overhang” include excessive cost of borrowings when a company struggles to raise further financing to fill its operating gaps.
The notes to 1MDB’s FY14 accounts detailing interest on borrowings (pg 122) show this to be the case: for example a RM1 billion “junior Islamic debt” drawn down in 2014 incurred a whopping annual interest rate of 18.1%.
Therefore, I must disagree with the Second Finance Minister’s contention that the recent emergency government loan to 1MDB “does not in any way constitute a bailout” because bailouts are only extended to “a failed organisation”.
He added that “the company was facing cash flow problems not due to management problems”. Successful companies plan their business operations, funding requirements and timescales responsibly, regardless of any possible returns that lie in the future, a company’s failure to plan to meet its short-term obligations invariably leads to bankruptcy.
This brings us to my next point about “going concern”, the fundamental principle upon which financial statements are prepared.
With the next financial year end March 2015 only two weeks away, I fail to see how 1MDB’s external auditors Deloitte can continue to rely on the appropriateness of this assumption without an explicit guarantee by the company’s shareholders, the MOF, that it will meet the company’s financial obligations.
In short, 1MDB can no longer be considered a “going concern” (an entity ordinarily viewed as continuing in business for the foreseeable future) without financial support from the Ministry of Finance i.e. the government.
I highlight this point of interest in view of widespread public concerns about possible “government bailouts” of 1MDB. Indeed in order to sign off the accounts of the company on a going concern basis, the external auditors would expect a letter from the shareholders, MOF, stating its explicit commitment to provide the necessary financial support to 1MDB.
The alternative would be for the financial statements to be prepared on a non-going concern or “break-up” basis.
Parallel to these developments is the startling revelation in blog and press reports claiming 1MDBs links with fraudulent and criminal activities (The Sarawak Report, The Sunday Times UK. The latter claims to have “seen” relevant email evidence).
In my previous article, I analysed publicly available information which signals “alarm bells” or “red flags” suggesting the possibility of irregular or fraudulent activities indicated by 1MDB’s frequent changes in external auditors, multiple and inexplicable late filings, unusual revaluation policy which served to mask its balance sheet insolvency, as well as the mysterious circumstances of the origins of the notorious US$2.3 billion Caymans funds.
The AG: His findings on 1MDB eagerly awaited
Significantly, the revelations in these blog and press reports have culminated in an instruction to the Auditor-General (AG) to conduct a public audit of 1MDB, an engagement I had called for more than four months ago.
Notwithstanding the possible conflict of interest arising from the instruction given by the Prime Minister who is also the Finance Minister and Chairman of 1MDB’s advisory board, I welcome this move of a public audit and hope the AG will undertake his heavy responsibilities with independence and credibility.
Critically the task requires a forensic audit (a specialised branch of audit which plays a crucial role in investigating suspected financial fraud and misappropriation of assets) with assistance from external specialist forensics if necessary.
For a methodical approach demonstrating credibility to the public, deadlines and time frames should be established, as well as clear terms of reference for the audit which should be made publicly available. These are crucial to allay public fears about the efficacy and intent of the public audit. The terms of reference should include but not be confined to the following:
- determine adherence to principles of corporate governance by 1MDB’s board and management;
- assess all evidence to determine any incidences of corporate malfeasance;
- determine the authenticity and validity of a number of 1MDB’s controversial transactions and the extent of potential prejudice the company may have suffered through such transactions .This includes the joint venture with Petrosaudi; portfolio investment in offshore Caymans funds; the bond issue via Goldman Sachs; the option agreement with Aabar and compensation thereof relating to the proposed IPO; the joint venture with Aabar undertaken by 1MDBs former subsidiary SRC involving RM4 billion EPF funds, including investigating the reasons for and circumstances surrounding the transfer of the company’s ownership to the MOF; and,
- quantify the magnitude and timing of 1MDBs current obligations and likely restructuring and financing cost.
All of the above will necessitate extensive work to (i) trace the flow of funds and other assets. (ii). construct a detailed chronology in order to understand and trace complex sequence of events of the company’s various transactions iii. identify relevant persons to interview, and conduct and document the interviews without fear or favour.
The interviewees should include current and previous management, current and previous members of the board of directors and advisory board, current and previous external auditors, any other persons including external advisors and associates who may be directly involved in the company’s transactions under investigation and any other persons who may be directly implicated by corporate malfeasance and fraudulent activities.
In view of the international nature of the company’s transactions and flow of funds and assets, the AG needs to assess the possibility of early referrals to criminal authorities to facilitate cross-borders investigations.
Assistance from and cooperation with PDRM, its overseas counterparts, Bank Negara and other relevant authorities will be essential.
In other words Tan Sri Ambrin Buang, good luck! The nation is depending on you to conduct this complex and critical undertaking with courage, integrity and professionalism.
* A.H. Manaf reads The Malaysian Insider.
* This is the personal opinion of the writer or publication and does not necessarily represent the views of The Malaysian Insider.