The Budget Method
192 This method was not identified until Mr Kelly had produced his "hybrid" Schedule on 4 October 2000. Mr Kelly and Mr Banks met subsequently to discuss the issues and Mr Banks produced a further report dated 6 December 2000.
193 The starting point for the budget method is "a notional" or "base" budget for the services provided by Management. A profit margin is added to the base budget and notional budgets for prior years are established. It is submitted that once these budgets are established it is possible to calculate the required contribution from each proprietor on a unit entitlement basis.
194 As certain costs are not recovered, it is necessary to add a cost of capital factor to recognise the circumstance that Management has had to carry the costs until they are recouped. Mr Banks assessed this factor in the range 15% per annum to 25% per annum.
195 Mr Banks described the budget method as an attempt to look now at what would be a budget for Management to provide services, the costs of which are not recouped through Deferred Management Fees and to project it back in time. In describing the difference between the budget method and the cash flow method Mr Banks said:
The cash flow was looking at the costs by way of cash incurred by Fernbank Management over time and adding an interest component which was a cash cost to its figures. The budget based approach is looking at a fair charging method, what is fair to actually charge for it and includes in concept a profit component based on fair return to an investor.
(Tr. 250)
196 The budget method excludes extraordinary items, such as the consulting fee of approximately $118,000 and the legal expenses relating to the Gillett proceedings and the unrecouped legal costs of prior sales of units. Mr Banks agreed that other Items should not be included in the base budget for the future but should be included on an historical basis. These were Item 12, "subsidy" and Item 14, "expenditure on behalf of the Owner's Corporation". Mr Banks' rationale for including these on an historical basis was his opinion that they were costs appropriately incurred. Mr Kelly disagreed with such an approach.
197 Mr Kelly and Mr Banks agreed that the costs of the sleepover apartment (Item 1), the live-in administrator's Lot (Item 2), the plant, equipment, furniture etc (Item 4), the utility deposits (Item 5) and Head Office capital expenditure (Item 16) should be removed and replaced with a notional rental figure on the basis of a sale and lease back. Although Mr Kelly was originally of the view that such should be at 6% and Mr Banks was of the view that it should be 8%, subsequent meetings apparently facilitated an agreement at 8%.
198 Mr Kelly and Mr Banks agreed that a figure of $300,000 should be included in the base budget for Head Office overheads (Item 13), however Mr Kelly did not agree to the appropriateness of the figure and had not formed a view on the appropriate method of allocation. Mr Banks accepted Mr Reid's estimate of $360,000 and discounted it by approximately 20% to reach the figure, $300,000. Mr Banks was of the view that such a discount reaches a most reasonable figure having regard to the fact that if a stand alone function was provided it would be higher than that figure. Notwithstanding this approach Mr Banks gave the following evidence:
Q Do you agree with me that if you just look at the part of Fernbank devoted to self-care units as a whole, but allow for the fact that there is both a body corporate, which functions in the ordinary way and a strata management company which provides the usual services by such companies, there is relatively little extra that is required to do for the ordinary operation for that part of that village?
A I would have thought that to be true.
(Tr. 272)
Q I suggest to you that on its face $300,000 is an excessive amount for overheads, taking into account the historical level of annual expenditure on behalf of the Owners Corporation and the various costs that you allow in addition in the base budget?
A I think there are a number of areas - $300,000 was allowed for the base budget, even though the Owners Corporation has had some work done for them. No profit component is shown for the year; it has been part managed over the years; at times $400,000 has been expended and managed on behalf of the Owners Corporation.
(Tr. 273)
199 A further matter of controversy in relation to the historical figures of the head office overheads was that the amounts included Management Fees charged as an expense, the detail of which was unspecified. Apart from the first two years of operation the head office functions have been provided by the Gandel Enterprise Retirement Trust (the Gandel Trust). The Gandel Trust also provides Head Office functions for a number of other retirement villages.
200 The Management Fees range from $618,000 in 1988/1989 down to a figure of $343,087 in 1992, to $267,020 in 1998 and to $468,412 in 1999. Mr Banks did not see the supporting documents in relation to the Management Fees but when he made enquiries about the amounts he was informed that they "related to salaries and on-costs of a number of executives".
201 The accounts also revealed inter-company lending and borrowing of substantial amounts of money and the charging and payments of interest. Mr Banks conceded that he was not aware of the amount of time head office employees would have spent in relation to these activities.
202 The approach adopted in respect of allocation of overheads in the historical budgets is a formula of taking the total amount of costs and dividing them by the number of apartments at the Village and each of the other Retirement Villages operated by the Gandel Group. It was suggested to Mr Banks that an alternative, and more appropriate, approach would be to have regard to the number of staff employed at each of the villages rather than the number of units at each of the villages. Mr Banks did not have any information about the number of staff or the operating costs of the other villages. He did not have any information about the level of services provided at each of the other villages to enable a comparison of those levels to be made.
203 Mr Banks accepted that the approach which has been adopted of apportioning overheads with reference only to the number of units in each Village, does not take into account the prospect that head office costs of managing some of the villages may be greater than others. Whatever be the historical costs and their allocation, Mr Banks' firm view was that $300,000 as a base budget was in the circumstances a most reasonable charge upon which to base an assessment of reasonable remuneration for Management.
204 Another area of controversy in the budget approach is Item 6 "support services availability/provision". This cost in the base budget is $65,000. Mr Banks conceded the historical figure over the period 1986 to 2000 of $1,081,330 included a figure of approximately $850,000 representing the shortfall in recovery of operating expenses of the Hostel. Mr Banks gave the following evidence:
Q Did you utilise the $1.08 million in the way it was accumulated in any manner in determining this figure of $65,000 under the column "Base Budget"?
A I did, by division, to get what the average was, but in my mind it had nothing to do with the actual historical figures. I was just trying to get some estimate of support figures or some minimum figure of the support figures.
Q I just haven't had time to do the arithmetic but the $65,000 is that some arithmetical derivation for the total for the period, taking into account the number of years?
A Yes.
Q And so it follows, does it, that in your $65,000 estimate as the base budget, that will have a substantial component which is attributable to and, if I might put shortly, shortfalls in recovery from the hostel occupants by reason of vacancies?
A That is how it was originally calculated but that is not the purpose of putting it in the budget.
Q No, do not worry about the purpose. We are just worrying about the figures for the moment?
A The figures, that is where the figures came from.
Q On what basis did you use the historical data which included any shortfalls in determining an ongoing base budget for support services?
A I did a division to get the figure of $65,000. On those figures, I looked at them and said in my mind, "What is an appropriate figure for going forward"?
Q Could you just tell me how you did the division?
A I put this 12 years into $1 million.
Q So you divided the $1,080,330-odd by 12?
A That was how it was to be spent. That was a figure, when I thought there's seven nurses full-time employed, there would need to be some proportion, and I heard people talk of half their time would be spent with the lot proprietors and half with the hostel, but when I looked at the costs for them of getting an emergency button and I got two or three quotes and I put them in my affidavit. It was $1 a day for a phone call not to just get the nurses there. I thought the $65,000 was a reasonable figure and that was for service and I thought I would adopt it for the purposes of the exercise.
Q But did you actually, when you were determining the $65,000 figure, have in front of you and take into account evidence about the extent to which historically nurses have been paid for by the hostel?
A Sir, to me that is an irrelevance. An irrelevant cost if somebody else - you know, whatever they are paying for in the hostel has no relevance to what the lot proprietors are paying. It cannot be a comparison. If the lot proprietors are using a service, I tried to work out a fair charge for those services. You should be trying to work out a fair charge without saying someone else should be paying for it. This is a different exercise. They are using nurses and they are using support services, they should pay a fair charge. Any charge under $65,000 is a fair figure. I only got the figure because of what has been charged in the past.
Q You have not set out in your report, correct if I am wrong, any detailed assumptions about the proportionate use of nurses by self-care unit owners, the hostel occupants, have you?
A No, I have only heard it, I haven't seen the evidence.
Q When you say you have only got that figure because of what has been charged in the past, what you are referring to there is the figures that appear in line 6, correct?
A That is correct, your Honour.
Q Now if my statement is correct, that of $1.08 million-odd, in the order of $850,000 is a shortfall in operating recoveries from the hostel, that would lead to some figure approximately $200,000 for the period for other support services - that is correct, simply as a matter of arithmetic?
A It doesn't account for doing the base budget. I probably should have, in all honesty, started with a clean sheet and said forget the previous figures and start from scratch with what sort of rates they had and add them all up, one by one, and go through an interrogation exercise and have to prove it in court. What I did, I divided that $1.08 million and got $65,000 and said, is it a reasonable figure, it has to be something more than that and therefore I will accept $65,000 for it.
Q But why as I understand the question, if you got 65 from the historical figures, it has nothing to do with what services were used and it has nothing to do with whether a room was occupied or not. How does it have any bearing on what the residents use at that place?
A Your Honour it hasn't.
Q It is unhelpful isn't it, Mr Banks?
A As a minimum figure it is. I think it is helpful as a minimum figure.
Q Assume the hostel had been full, the figure in the final column would be zero.
A I should have come along, your Honour, and actually worked out that if we were working at base budget, we should have started with a clean sheet and worked out all the services they were really using.
(Tr. 257-259)
205 If one divides $1,080,330 by 12 or even by 14 or 15,taking into account the years 1986 to 1999 /2000, the outcome is higher than $65,000, being $90,027, $77,166 and $72,022 respectively. It therefore does not seem that the $65,000 could be reached by a simple division of the total of the overheads over the years.
206 Mr Banks' alternative suggestion that the $65,000 represented $1 per day per unit for having the emergency call button available does not seem to be sustainable. The arithmetic is $365 per annum ($1 per day), multiplied by 197 (156 self-care units and 41 Hostel units) which gives a total of $71,905. If the Hostel units are excluded and $365 is multiplied by 156 a figure of $56,940 is reached. The method of achieving a figure of $65,000 therefore remains a puzzle.
207 I am of the view that it would be inappropriate to include the $850,000 in the historical figures in the budget method. If one removes that proportion from those figures a total of $231,330 is reached and if one then utilises the original approach claimed to have been adopted by Mr Banks in his evidence by dividing it by twelve, a figure of $19,277.50 is reached. Thus a reasonable base budget would be to round the figure up to $20,000. That would reduce the total figure in the base budget by $45,000.
208 A further matter of controversy between Mr Banks and Mr Kelly was the subsidy (Item 12). Mr Banks' evidence on this topic included the following:
Q Is it the case, notwithstanding your reference in your report that you have referred to, that is, 6.41.1 you simply do not know what those items are in the first four columns in line item number 12?
A That is correct.
……….
Q But you cannot tell me, a simple question, you cannot tell me what the figures relate to?
A No.
(Tr. 264-265)
209 The cost of capital component is also included in the base budget. Mr Banks expressed the opinion that if a business is going to operate profitably over the long term, it needs to recover required rates of return acceptable in the market place. Mr Banks was of the view that at the time of the hearing 18% was an acceptable rate of return but that it had been higher during the years that the Village has operated. Mr Banks understandably stated that if one didn't recover that return the value of the business would reduce year by year.
210 As to the compound interest claimed by Management, Mr Banks gave the following evidence:
Q Am I correct in understanding your opinion that you say it is necessary to compound the rate of return to Fernbank Management over the period, the historical period?
A Yes. I will give you an example sir. If you have some shares and you are earning a 15 percent dividend and you get paid every year and you put it in your pocket, spend it or invest it. If you don't get it for 10 years, it is not logical only to give you $150 dividend on your thousand. You need to get some compound. Are you reinvesting your money every year. That is what Fernbank Management is required to do. It is required to put $1,000 in the first year, get some profit margin from it, reinvest it into money next year and next year and next year because it hasn't got any return for that lot proprietor for an average 12 years. When you get to the end of it, then they get a profit out of it. They have to pay tax on it and everything else goes and they can recover everything. If you don't compound it, it is like an investment which you are just accumulating a single figure each year.
Q In answering that question are you directing your mind to the task that her Honour might face in various eventualities of determining a reasonable remuneration each year in the past for the services provided by Fernbank Management?
A If you came to have to do a reasonable remuneration in one year, you may add a profit margin and say that's the remuneration for that year. You could do that with a profit margin every year. If you try to look at a reasonable return for the investment, you should go back one step before the profit margin. That's the investment you had before the profit margin, it is the cash invested and that cash each year should be treated as an investment that compounds at your required rate of return, cost of capital.
(Tr. 281-282)