Why GEOS Melbourne Shut its Doors

Thanks to a kind reader, I received a copy of Ernst & Young's report to creditors on the closure of GEOS Melbourne. Many comments have been made about how GEOS siphoned its Australia schools dry, and the report offers an explanation as to how that happened. I've summarized key parts of the report to illustrate why GEOS Melbourne suddenly went into voluntary administration.

First, let's deal with the question about ownership of the GEOS Australia schools. When GEOS Japan issued its "apology" in February, it tried to downplay the affair by saying that the schools were locally incorporated businesses, that the decision to close was made locally, and that none of this affected GEOS Japan. The first two reasons may technically be true, but when it comes to that last one, the Ernst & Young report leaves you wondering how the closure of GEOS Melbourne and all of the other GEOS schools in Australia can't have anything but a negative effect on GEOS Japan. As of February, 23, 2010, the date of the report, Appendix A on page 30 carries this organization chart (click for larger image):

The GEOS Australia schools may be locally incorporated, but they are be 100% owned by GEOS Japan. Furthermore, the report states that as of October 15, 1996, Tsuneo Kusunoki was one of GEOS Melbourne's directors and that:

GEOS Melbourne is a 100% owned by GEOS Corporation (Japan). GEOS Corporation owns all 100,000 fully paid $1 shares in the Company (p.6).

The sudden closure of the school is curious given its recent performance. The table shows that the school's revenues had been increasing since FY07 (p.6).

The report notes:

GEOS Melbourne has been operating profitably for the previous two financial years (FY07 and FY09) as well as for the 6 months to 31 December 2009. Steady growth in profits has been seen due to growth in revenue coupled with a decrease in marketing, teaching and administration expenses as a percentage of revenue. (p.7)

Melbourne was profitable for the past two and a half years right up until its closure. Here's GEOS Melbourne's balance sheet.

Of concern here are the Receivables - Loan GEOS Australia Holdings and Receivables- Loan related entities under Non-current assets, and Dividends Paid under Equity. It is the loans to GEOS Australia Holdings which are at the heart of why the school closed.

Receivables - Loan GEOS Australia Holdings

The Victorian Regulation and Qualification Authority (VQRA) stopped the Melbourne school from accepting new enrollments in December 2009 after investigating an accounting report prepared for it by GEOS Melbourne. The departure of senior management personnel and the change in student enrollment hurt the school's revenues in the first half of FY10. The report goes on to say:

During the same period, a umber of other entities in the GEOS Australia Group were experiencing financial difficulties. This led to the directors to begin to understand that the ability of all companies in the Group to repay outstanding intercompany loans may be compromised. Without the repayment of these loans, the Company could not cover future obligation. It was on this basis that the directors appointed the Administrators.

The majority of excess cash generated from the operations of GEOS Melbourne appears to have been used in one of three ways, payment of dividends, loans to related entities and retained in GEOS Melbourne's bank account (p.10).

This table shows that much of the money went to other GEOS-related entities (p.10).

The Ernst & Young report concludes:

The ability of the related parties to re-pay the loan amounts outstanding was crucial to the ability of GEOS Melbourne to continue to trade. Without the repayment of the above loan, or the ability to raise cash from other sources, GEOS Melbourne did not have sufficient funds to continue operations (p.11).

The dividends of $633,755 and $1 million were paid by Melbourne GEOS to GEOS Japan (p.10). They were not cash payments, but a reduction in the balance of the GEOS Australia Holdings loan (p.11).

Receivables - Loan related entities

As for money that went elsewhere within GEOS, the report lists the following amounts (p.13):

The Administrator's comment on the money:

On 4 February 2010 the Administrators issued a demand on GEOS Australia Holdings in relation to the debt payable to Melbourne. Given that GEOS Australia Holdings did not operate in its own capacity other than to act as a holding company for other members of the GEOS Australia group, the Administrators questioned the ability of GEOS Australia Holdings to repay the outstanding amounts. Further, it is also the Administrator's understanding that a large amount of the funds provided to GEOS Australia Holdings were further lent to other GEOS entities globally and as such may not be readily available for repayment.

A similar situation exists for the amount outstanding from GEOS Cairns Pty Ltd (administrators appointed). The Administrators were also appointed to this company on 29 January 2010.

As such, the Administrators have estimated the realizable value of these assets as nil (p.13).

According to the Administrators, a school that was profitable for the past two and half years was making loans to a GEOS holding company with no prospect of those loans ever being repaid. The money is gone, funneled back to Japan and to other parts of GEOS.

Another interesting tidbit in the report is that upon taking over GEOS Melbourne, the Administrators met with representatives of GEOS Japan and related entities in Australia to discuss whether money would be made available to the Administrators so they could reopen the school. GEOS Japan gave them no money. The Administrators were forced to announce the closure of GEOS Melbourne to staff and students on February 1. For whatever reason, GEOS Japan chose to not bail out a profitable school.

Investigations

Apart from trying to rehabilitate GEOS Melbourne, the Administrators also investigated the school's business to understand the circumstances of its failure and form an opinion as to how it would act in the interests of GEOS Melbourne's creditors. Under the Corporations Act, the Administrators identified seven offenses that warranted further investigation.

1. Failure to exercise reasonable degree of care and diligence
2. Failure to act in good faith
3. Making improper use of position to gain advantage
4. Making improper use of information to gain advantage
5. Reckless or intentional dishonesty in failing to exercise duties in good faith
6. Failure of director to disclose interest in contract with company
7. Being a director at the time when an insolvent company incurs a debt and there are reasonable grounds for suspecting the company to be insolvent. (p.18)

In examining the actions of the directors, the Administrators believe making loans to GEOS Australia Holdings to be a breach of good faith as GEOS Australia Holdings had no means to repay those loans (p.19). Those loans left GEOS Melbourne with insufficient funds to operate.

The Administrators identify $2,273,975 in uncommerical transactions, transactions that have no benefit or are detrimental to the company. Of that amount, $725,521 went to GEOS Australia Holdings and $1,144,500 to GEOS Japan, with the remainder going to other GEOS entities ($220,000) and a $1 million dividend. Here's a breakdown (p.21-22):

The Administrators concluded that GEOS Melbourne received no benefit from these transactions and that the loans left the school with no money to continue operations (p.22).

On the other hand, the Administrators found that GEOS Australia Holdings did benefit from the loans and may have become insolvent had it not received the money since it had no other means of generating income. The Administrators still do not understand the purpose of the loans but believe that "…in the past 18 months, approximately $1.36m was made available for the purposes of transfer from GEOS Australia Holdings to GEOS Corporation (Japan) or other GEOS entities (p.23)." Unfortunately, the Administrators feel that recovering the money from GEOS Japan is unlikely due to the cost involved, but think that going after the related companies may be worthwhile. However, without funding from creditors it doesn't appear that the money will ever be recovered.

Unreasonable director-related transactions (UDRT)

The report notes that some transactions between with GEOS Australia Holdings may be UDRTs as the directors of GEOS Melbourne are also directors of GEOS Australia Holdings, and one director of GEOS Melbourne is director and chairman of GEOS Japan (p.23).

Insolvent trading

The Administrators ask two questions:

• How likely were the loans made to GEOS Australia Holdings to be paid back?
• Is it reasonable to assume that GEOS Australia Holdings was insolvent? (p.24)

This matters because GEOS Australia Holdings' net assets over the past three years was negative. If it was trading while insolvent, the actual date the loans was considered unrecoverable needs to be determined in order to take action against the directors (p.25).

However, the directors did place GEOS Melbourne into voluntary administration when they were aware that the money from GEOS Australia Holdings would not be recovered, so they may have a valid defense against any recovery action. Although it appears that GEOS Australia Holdings was insolvent for some time, further investigation is required to determine the point it became insolvent .

The dividend

As already noted, a dividend of $1 million was paid to GEOS Melbourne's shareholder, GEOS Japan in the form of a reduction of the outstanding loan from GEOS Australia Holdings (p.25). Since no cash was involved, there is nothing to be recovered. The Administrators also note that by law, dividends may only be paid out of profits and that statutory and common law principles have to be applied in assessing whether or not the dividend complied with the law.

Recommendations

The Administrators are of the opinion that their appointment should be terminated, that GEOS Melbourne is insolvent, and that it should be wound up by the Court. They recommend that it is in the interest of creditors to place GEOS Melbourne into liquidation (p.26). However, as of this report, the Administrators believe that there will be insufficient funds to pay any unsecured creditors (p.27).

That's the bulk of the report. The money funneled off the Japan will likely never be seen again and GEOS Melbourne doesn't have any assets of value with which to pay off any creditors.