Part 17: Funding and financing changes during construction
17.1
In this Part, we discuss:
- the changes that the Council agreed to make to how the project would be funded;
- how KDC started to use interest rate swaps;
- the changes to the timing of the project that meant the swaps needed to change;
- what the Council was told about these financial issues; and
- our comments.
17.2
In summary, we conclude that the Council managed the financing of the project very poorly. The Council took no steps to get any independent advice about whether the debt financing was appropriate and competitive with what was available in the market. The Council's understanding of the financing arrangements was so poor that it failed to appreciate that changes to the scope of works would have financial consequences. The Council should have had much stronger oversight of the financing for the project, including the debt financing.
17.3
We have not discussed the issues that KDC had with the rates that it levied in this period. Clearly, there were problems with the rates levied for the wastewater scheme, and the rates were defective. We have not discussed these issues in this report because they are discussed in detail in the Validation Bill being considered by Parliament and are also the subject of judicial review proceedings in the High Court.
Changes in the way the scheme would be funded
17.4
The Council considered the rates and development contributions to fund the wastewater scheme at its meeting in November 2007. The Council next considered this issue in March 2008. The Chief Executive provided a report to the Council recommending the rates and charges set out in the last column of Figure 12, which we have compared to the figures set out in the 2006 Statement of Proposal.
Figure 12
Changes to rates and charges from June 2006 to March 2008
| Rates and charges | 2006 Statement of Proposal (GST included) | March 2008 (GST included) |
|---|---|---|
| Uniform annual charge | $630.00 | $692.90 |
| Uniform targeted rate (pre-2002 ratepayers) | $2,000.00 | $2,654.10 |
| Uniform targeted rate (post-2002 ratepayers) | $6,862.50 | $7,516.60 |
| Development contribution | $11,060.00 | $12,183.80 |
Source: 2006 Statement of Proposal, Option 3.2, page 24 and Council minutes, 26 March 2008, page 16.
17.5
The Chief Executive's report advised that the rates and charges had been calculated using the funding model PwC (Australia) developed. The model assumed that 4500 sections would be connected after 25 years. The rates and charges also included an escalation to account for the increases in the CPI.
17.6
The report also noted that capital expenditure on the project had increased from $53 million in November 2007 to $57.7 million in March 2008.
17.7
The Council adopted the Chief Executive's recommended rates and charges.
17.8
Rates were first levied for the scheme in 2008/09 and were the same as the rates agreed at the Council's March 2008 meeting. Concerns about the rates first began to be raised in 2009.
Kaipara District Council's use of interest rate swaps on its loans
17.9
Interest rate swaps are a financing instrument that involves a contractual relationship between a financier and a party who wishes to manage their interest rate risk. The normal use of interest rate swaps by local authorities is to change the interest rate from floating to fixed. This gives the local authority certainty about its exposure to rising interest rates.
17.10
As we set out in Part 12, KDC signed an International Swap Dealers Association agreement with ABN Amro in December 2007. Under the contract documents:
- When the Land Acquisition Facility Agreement was signed in December 2007, it was decided to use a floating interest rate.
- The Term Loan Facility Agreement also had a floating interest rate.
- At Commercial Acceptance 1, KDC would draw down funds under the term loan to repay what it owed under the Land Acquisition Facility Agreement and to pay MDHL the purchase price of the completed facilities.
- At Commercial Acceptance 2, KDC would draw down more funds to pay MDHL the purchase price for the remaining facilities.
17.11
In April 2008, ABN Amro provided EPS with advice about whether to use an interest rate swap for these two agreements. The paper set out that the current floating interest rate was 8.80% a year. ABN Amro advised that interest rates were unlikely to ease in 2008, and it recommended that KDC fix the interest rate on the debt KDC expected to incur between May 2008 and August 2009 (comprising the loan to purchase the farm and the drawdown at Commercial Acceptance 1), by using an interest rate swap to fix the rate at 8.36% for that period. This provided certainty for KDC.
17.12
ABN Amro advised that, if the floating rate increased, KDC would save money in interest payments. The reverse also applied – that is, if the floating rate reduced, KDC would be unable to take advantage of the lower rate – but this was not explained to the Council.
17.13
The ABN Amro paper noted that, if the Commercial Acceptance 1 date and drawdown (which was to be on 1 January 2009) was delayed, "the value in the existing swap can be retained and embedded in a new swap with a new modified debt tranche". However, the paper did not explain that doing this would incur costs or what those costs would be. We note that the 1 January 2009 date was a mistake: the date for Commercial Acceptance 1 was 7 February 2009.
17.14
The KDC's Finance Manager reviewed the advice. In an email to EPS, which was also copied to the Chief Executive, the Finance Manager noted that:
Local government is not in the business of second-guessing interest rate movements. It's too much like speculation. Were you not talking earlier this year of seeking some independent advice of your own to double-check on the ABN advice?
17.15
EPS replied to the Chief Executive that:
We could get some further independent advice but I think that ABN's advice, whilst not being totally at arms length, does not benefit them in any way that I can see. As part of the partnership for Mangawhai, I suggest we should accept their advice. We can review the position again at CA1.
17.16
We could not find any response from the Chief Executive in KDC's files. However, it appears that the Chief Executive agreed to enter into the swap.
17.17
In a paper to the Council in March 2008, the Chief Executive recommended fixing the interest rates for the Land Acquisition Facility and for the construction period between Commercial Acceptance 1 and 2. His paper set out that the rates were currently not fixed and that:
… in the current environment this has the potential to increase costs by approximately $90,000 if the ABN Amro and other market predictions prove correct.
… advice had been received from ABN Amro that it is possible to hedge against future interest rate rises during the construction phase.
17.18
The paper did not set out that the mechanism to fix the interest rates was a swap or that there were costs and risks in using such instruments, particularly where the timing of the underlying borrowing being hedged is uncertain. Importantly, the paper did not draw attention to the fact that what was being proposed was not consistent with KDC's Treasury Management Policy and that the steps required by that policy to manage risk had not been followed.
17.19
KDC's former Chief Executive told us that KDC's Finance Manager would have drafted the report to go to the Council. He told us that he does not recall being told that there was a breach of KDC's policy. If it had been raised, he would have advised the Council of this. He told us that he believed that "there was significant financial benefit to Council. The bank was consistently asking Council to change these arrangements. They were disadvantaging the bank." We were unable to verify from KDC's files whether KDC's Finance Manager prepared the report.
17.20
The Council agreed to fix the interest rates on the Land Acquisition Facility, and for the construction period between Commercial Acceptance 1 and Commercial Acceptance 2, up to August 2009.
Changing project dates meant the swap had to change
17.21
ABN Amro set up the swap to start from 1 May 2008, which effectively fixed the interest rate that KDC was paying until 6 August 2009. However, as set out in paragraph 17.13, the swap was based on the drawdown for Commercial Acceptance 1 occurring in January 2009. The contractual documents and loan set out that two drawdowns would be made on the loan to pay for the scheme at Commercial Acceptance 1 and Commercial Acceptance 2. It appears that the swap did not match with the expected cash flows under the contracts and loan. We do not know why neither ABN Amro nor EPS identified this mistake.
17.22
In late December 2008, it had become clear that the date for Commercial Acceptance 1 was going to need to change because of the modifications. ABN Amro advised EPS that, if the date were to change, the swap would need to be broken and that there were costs to doing this. In an email in December 2008, EPS noted that the floating rate had dropped. EPS discussed the costs of breaking the swap with ABN Amro and set out that the date for Commercial Acceptance 1 had always been February 2009. EPS also stated that the dates for commercial acceptance were always subject to change, that ABN Amro had been told this, and that any break costs were for ABN Amro to deal with.
17.23
ABN Amro acknowledged that the date for Commercial Acceptance 1 was supposed to be February 2009. However, it did not agree with EPS' view that the break costs were ABN Amro's problem. It advised that the swap agreement was based on the cash flow model that anticipated the drawdown for Commercial Acceptance 1 in February 2009. As Commercial Acceptance 1 was not going to happen until somewhere between June and August 2009, the swap either needed to be closed out or restructured. Because interest rates had fallen since the swap was entered into, there was a cost to close out or restructure the swap.
17.24
ABN Amro noted that the Land Acquisition Facility would need to be extended beyond its expiry date of February 2009 because of project delays. The amount of the facility also needed to be increased to cover the increase in capitalised interest payments that would need to be made. As the banks' cost of financing had increased because of the change in global financial markets, ABN Amro advised that there would be increased costs to changing the Land Acquisition Facility.
17.25
ABN Amro provided EPS with advice about how the break costs were calculated. It also set out what the projected interest costs would be, based on several floating interest rate options.
17.26
EPS advised ABN Amro that KDC had agreed to close out the swap. In an email to EPS in February 2009, ABN Amro proposed to fund the swap break costs of around $825,000 through a drawdown under the Land Acquisition Facility. It agreed to increase the amount of the loan under the Land Acquisition Facility Agreement to $7.5 million and to extend the expiry date from 28 February 2009 to 31 December 2009. ABN Amro charged an upfront fee of $7,500 to do this and increased the margin on the Land Acquisition Facility from 0.55% to 1.5% each year. EPS advised ABN Amro that KDC agreed to this. ABN Amro advised that the swap was closed out and that the cost to KDC was $840,000.
17.27
It appears that the Land Acquisition Facility Agreement was amended in February 2009. The amendment is largely in the terms set out above. It sets out that the swap termination costs were $840,000.
What the Council was told
17.28
EPS prepared a report about the cancellation of the swap agreement in February 2009. Several drafts were prepared. The report set out that interest rates had fallen because of the global financial crisis and that the margins banks were charging for loans had increased. The report stated that:
ABN Amro and Beca/EPS International have been in negotiations since late 2008 to restructure or cancel the swap arrangement to enable Council to take advantage of the lower interest rates now available. The fixed interest rate swap has now been closed out and it has been agreed to convert the Construction Funding Agreement to a floating rate.
17.29
The report set out that swap break costs were $840,000 and that the margin on the Land Acquisition Facility for March to August 2009 had increased from 0.55% each year to 1.5% each year. However, the report did not explain that the swap needed to be broken and that the increased margin needed to be paid on the Land Acquisition Facility because modifications meant the date for Commercial Acceptance 1 could not be met.
17.30
The report noted that there would be "significant savings to be gained through the period from March 2009 to August 2009 which off-set the above costs based on current projections". One draft of the paper put these savings at $75,000 to $175,000 after deducting break costs. A later version of the draft put the range at $750,000 to $875,000.
17.31
This later version of the draft appears to suggest that, at the same time as breaking the swap agreement, the interest rate payable on the Construction Funding Agreement between EarthTech and ABN Amro would be converted to a floating rate. Assuming the floating rate remained at 4% each year until August 2009, EPS estimated that about $700,000 could be saved. It is unclear how this would be achieved, because KDC was not a party to the Construction Funding Agreement and would have no control on the interest paid. KDC did not have a copy of the Construction Funding Agreement in its files, so we were unable to determine what the interest rate was or how it was to be set.
17.32
The report noted that:
The only real alternative was to continue to pay the fixed interest at 8.36% p.a. for the period up to August 2009 that would have increased the cost to Council with no offsetting savings.
17.33
In our view, this report was misleading. The reason the swap had to be broken was that the dates for commercial acceptance had changed. It is unlikely that KDC would have elected to use a swap to refix at the higher interest rate when its underlying loans were based on floating rates.
17.34
The report stated that ABN Amro had recommended taking the approach set out in the paper and "that PwC had also reviewed this position and confirmed that the general approach was sound". There were no copies of any advice about this issue from PwC (Australia) in KDC's files. The report went on to state:
In addition to ensure the integrity of the process it is recommended that [name] (ex ABN Amro) be engaged to conduct an independent review of the financing arrangements with ABN Amro to confirm ABN calculation and to recommend any potential other areas for savings.
17.35
This person had been the banker at ABN Amro and had been involved with the financing for KDC since at least 2005. He had provided the advice about entering into the swap agreement to KDC. He reviewed the final draft of the paper.
17.36
We tried to assess the estimated cost savings provided in the various EPS papers. We were unable to establish what the figures were based on or whether there were significant savings from breaking the swap. However, we would be surprised if there were any net savings from breaking the swap once the break costs of $840,000 were taken into account.
17.37
There was no record that this report was provided to the Council. We were not able to determine from KDC's files that the Council was ever advised that these costs had been incurred in March 2009. A paper reviewing the project prepared by the project managers appears to have been provided to the Council at a meeting in June 2010. This paper set out that a break fee was paid "to change the fixed loan to a floating line during the final stages of the construction period". However, the paper makes no reference to the use of swaps or why it was necessary to incur these costs.
Our comments
17.38
KDC managed the financing of the project very poorly. This was because, in the initial stages of the project, the Council failed to understand what it would need to do to manage the project and the limits of the services to be provided by the project managers. In particular, it needed to have independent financial advice about the debt financing arrangements it entered into. Because it failed to get this advice, KDC relied heavily on EPS for advice about debt financing issues and did not appear to have the advice regularly reviewed internally. As has become evident, KDC also did not understand the requirements of the rating legislation and how to set lawful rates.
17.39
KDC's use of interest rate swaps resulted in KDC incurring significant break costs when it became clear that the cash flows assumed in the swaps did not match the underlying cash flows being hedged, because of delays in the date of commercial acceptance. In our view, KDC did not adequately understand the nature of swaps when it entered into those transactions. KDC's Treasury Management Policy also required expert advice to be obtained, yet this was not done.
17.40
As we have discussed in other Parts, the debt financing arrangements for this project were complex and KDC needed to have independent expert advice about these arrangements. PwC (Australia) carried out work on the financing. However, we could not assess the scope of this work because it was commissioned by EPS and held in EPS' files. KDC did not have direct access to this information.
17.41
In any event, the advice provided by PwC (Australia) through EPS was what needed to be tested with independent advice. Even when KDC officers identified the need for some independent advice, it was not sought.
17.42
From what we have been able to determine from KDC's files, the Council was provided with very limited information about the debt financing arrangements. If the only information was that in the files, then, in our view, there would not have been enough information for it to make informed decisions about the debt financing issues it was asked to decide. In some cases, the information was so inadequate that the Council could not have understood what it was being asked to agree to.
17.43
In particular, we were surprised that the Chief Executive's reports to the Council for February or March 2009 did not mention that the date for Commercial Acceptance 1 would not be met. Nor was there any reference to the swap needing to be broken as a consequence. In essence, it appears that:
- The transaction may have been entered into without proper authority and in breach of KDC's policies.
- It cost KDC $840,000 to break the swap because of the delay to the date for commercial acceptance.
- The Council was not properly informed about what had happened.
17.44
In our view, the Council needed to have maintained much stronger oversight of financing issues and should have required the Chief Executive and its advisers to provide considerably more information than they did. The Chief Executive should have ensured that the Council's policies and processes were properly applied and that the Council was properly informed about such matters.