LONDON, Dec. 10, 2018 /PRNewswire/ --
Mrs. Carmen Iglesias Cano
Mrs. Maria Antonia Linares Liébana
Mr. Juan Rodríguez Torres
Audit and Control Committee of the Board of Directors
REALIA BUSINESS, S.A.
Av. Del Camino de Santiago, 40
By registered mail and e-mail
10 December 2018
Dear Sir and Mesdames:
We are writing to you as the investment manager for the Polygon European Equity Opportunity Master Fund and certain client accounts which collectively have an economic interest in excess of 10% of Realia Business, S.A.'s ("Realia") total share capital.
We would like to reiterate our concern, stated publicly at the General Meeting of Shareholders in June 2018, as is a matter of public record, and in letters to Mrs. Carmen Iglesias Cano and Mrs. Maria Antonia Linares Liébana in July 2018, about the use by Realia of the Order ECO 805/2003 of 27 March ("ECO") to value Realia's residential land holdings. We are particularly concerned about the use of this methodology as the basis for the preparation of the consolidated annual accounts of the company according to international accounting standards ("IFRS") since year 2012.
Polygon considers that the application of the ECO valuation methodology to Realia's residential assets is improper. It results in a significant understatement of Realia's land bank value and, in so doing, fails to present a true and fair view of Realia's assets as required by international accounting principles and international auditing standards.
First, the use of ECO cannot be justified on formal legal grounds.
As is clear from Article 2 of the ECO Order, the use of the ECO valuation methodology is prescribed in the following four circumstances only:
"(a) mortgage of credits or loans that form or will form part of the portfolio of coverage of mortgage securities issued by entities, developers and builders referred to in the second article of the Royal Decree 685/1982, 17 March, by which certain aspects of Law 2/1981, dated March 25, Regulation of the Mortgage Market, is developed.
(b) coverage for technical provisions of the insurance entities required by the Royal Decree 2486 / 1998, 20 November, which approves the regulation of management and supervision of private insurance.
(c) identification of the assets of the real estate collective investment institutions regulated by Royal Decree 1393 / 1990, of 2 November, which approves the regulation of the law 46/1984, of 26 December, regulating collective investment undertakings.
(d) determination of the real estate assets of pension funds regulated by the Royal Decree 1307 / 1988 of 30 September, which approves the regulation of plans and pension funds."
It is apparent that none of these circumstances applies with respect to Realia and the preparation of its financial statements.
ECO is a method that produces "appraisals" for very specific circumstances, and not "valuations" of assets.
By comparison, the RICS Valuation – Global Standards 2017 (the RICS Red Book) ("RICS") clearly contemplates in Part 5 Valuation Applications under VGPA1 that the RICS valuation methodology is appropriate for use by a company, such as Realia, that has adopted IFRS standards in its financial statements. Para 1.2 of VGPA1 goes on to make clear that:
"Valuations for inclusion in financial statements require particular care as they must comply strictly with the applicable financial reporting standards adopted by the entity."
Second, the ECO valuation methodology is only recognised in Spain for the very specific purposes specified in the ECO Order. Consequently, ECO cannot be used as the basis to prepare accounts for purposes other than as provided by the ECO Order and specifically cannot be used by a listed company such as Realia – which must prepare its accounts according to IFRS standards as required by EU accounting standards and practices. Such a use precludes the adequate comparison of the annual accounts of Realia with its comparable companies in the European Union. It is a fact that, of all the listed real estate companies in Spain, Realia is the only one using ECO to value part of its assets.
More specifically, standard IFRS 13 specifically refers to "fair value" in the following terms:
"A fair value measurement of a non-financial asset takes into account a market participant's ability to generate economic benefits by using the asset in its highest and best use or by selling it to another market participant that would use the asset in its highest and best use".
It is apparent from this definition that an "appraisal" for very specific purposes, as defined in the ECO methodology, is incompatible with the IFRS 13 standard. None of the circumstances stated in the ECO order are the "highest and best use" of the assets of the company.
There are two conflicting accounting principles: the principle of "prudence" and the principle of "fair view". However, both in the Spanish General Accounting Plan and the IFRS standards, there is no single principle that prevails over another, so the use of excessive prudence cannot prevent a fair representation of a company's assets.
More specifically, the Spanish General Accounting Plan requires that auditors ensure that "the information provided be comprehensible and useful for users to make economic decisions, and give a true and fair view of the assets and liabilities, financial situation and results of the Company".
IFRS has provided guidance as to the application of the principle of prudence such that:
"… the exercise of prudence does not allow, for example, the creation of hidden reserves or excessive provisions, the deliberate understatement of assets or revenue, or the deliberate overstatement of liabilities or expenses, because the financial statements would not be neutral and, therefore, not have the quality of reliability" (emphasis added).
Consultation 7 of the ICAC (BOICAC number 80/2009) on the "criteria applicable to the accounting of provisions for lower value of stocks and real estate investments by a real estate company", describes that in the case of stocks, it is the "net realizable value" as established in subsection 6 of the Conceptual Framework of Accounting that must prevail. This concept requires an appropriate measurement of the value that can be extracted from the asset if developed, once discounted the transaction costs of the sale, or lacking this development potential, at least the market value of replacing those stocks. This concept also is contrary to the stated objectives of the ECO valuation.
This is even recognised by TINSA, the valuer of Realia's land bank, in it Working Paper of 10 December 20131, where it seemingly advocates against the use of ECO to represent the "fair view" of a company's assets:
"Simply put, the principle or principles that must prevail are those whose application results in the annual accounts reflecting the most fair view of the company. This question is certainly relevant, since it is a point of clear differentiation with respect to the appraisals done for mortgage purposed according to Order ECO 805/2003 of 27 of March."
Third, with the above in mind, we now address the responsibilities of the Audit and Control Committee of the Board of Directors of Realia both generally, and in the particular circumstances of the potential understatement of Realia's assets.
According to Article 44 of the Regulation of the Board of Directors of Realia, as part of its duties, the Audit and Control Committee of the Board of Directors:
- will be liable for the selection process of the auditors.
- must obtain information from the auditors regarding the audit plan and the results of its execution.
- supervises the process of preparing and disclosing the mandatory financial information of Realia and supervise the process of preparation of the annual accounts.
- informs the Board of Directors regarding the correctness and accuracy of the annual accounts and other financial information of Realia.
Likewise, according to the Technical Guide 3/2017 approved by the Comisión Nacional del Mercado de Valores regarding the audit committees of listed entities, the Audit and Control Committee of the Board of Directors:
- must evaluate, based on the different information available (including the external audit) if the entity has correctly applied the accounting policies.
- will be liable for the selection process of the external auditor for which purposes must consider the scope of the audit, the capacity, experience and resources of the auditor and the effectiveness and quality of the services to be rendered.
- should discuss with the auditors on a regular basis the audit plan and the execution of the same.
- should discuss with the auditor the auditor's opinion regarding the quality and application of the accounting principles by the company.
- should discuss with the auditor the methods and hypothesis used by the management in the material accounting estimates, the effects of considering any alternative method or hypothesis, and the consideration by the auditor of data or information that might be contrary to the hypothesis used by the management.
- must review with the auditors the results of the audit process and the content of the audit report and issue a report regarding the audit process and how the auditor has contributed to the clarity of the audit and the integrity of the financial information.
- must inform the Board of Directors and, as the case may be to the supervising authorities, of any concern regarding the quality of the audit.
Based on the foregoing, as part of its duties to ensure the quality of the external audit and the correctness and accuracy of the annual accounts and other financial information of Realia, the Audit and Control Committee of the Board of Directors of Realia should ensure that the company's auditors, EY, complies with its statutory and contractual duties so that Realia's annual accounts present a true and fair view of the company's assets and liabilities. In particular, the Audit and Control Committee of the Board of Directors of Realia should ensure that EY complies with its obligations that derive from, amongst other sources:
- Articles 1.2 and 4 of Act 22/2015, of 20 July, concerning Accounts Auditing, and Articles 4 and 6 of Royal Decree 1517/2011, of 31 October, approving the Regulation that develops the recast Auditor's Act approved by Royal Legislative Decree 1/2011, of 1 July; and
- the generally accepted accounting principles under the Conceptual Accounting Framework of the Spanish General Accounting Plan, as adopted by the Royal Decree 1514/2007 of 16 November.
In this connection, the Audit and Control Committee of the Board of Directors of Realia must review whether EY, as the auditors, is complying with its obligation to present a true and fair view of Realia's financial performance and condition, and in particular whether the principle of prudence and fair view have been correctly observed.
ECO is a valuation methodology that is significantly more conservative than RICS, by its nature and stated legal purpose. As a result, the use of ECO results in a significant understatement of Realia's assets, especially when compared with Realia's direct competitors in the Spanish market.
In circumstances where EY has audited Realia's financial statements, and those statements include a valuation of Realia's commercial assets assessed using the RICS valuation methodology, and therefore EY must be taken to have accepted the RICS guidance of VGPA1, it is inexplicable to us how, in the same financial statements, EY could also approve without any qualification the use of the ECO methodology to value residential assets. This is all the more so in circumstances where EY is the auditors of two of the five other listed Spanish real estate companies, namely Aedas and Quabit, both of which use the RICS valuation methodology (as, in fact, do all of Realia's listed competitors).
We acknowledge that EY has included in Realia's recent financial statements a list of "key audit issues". These include Realia's inventory and investment property valuations in light of (1) the significance of the amounts involved and (2) the high degree of sensitivity to those valuations when changes in the underlying valuation assumptions are made. However, in circumstances where ECO cannot be justified on legal grounds or in accordance with accounting principles, EY should have gone further by qualifying its opinion of Realia's financial statements. It is striking that in its annual audit reports for Realia, EY avoids any comment approving the appropriateness of the valuation methodologies used by Realia, including in relation to (1) whether it is appropriate for Realia to use two different valuation methodologies (where formerly only RICS was used), and (2) whether ECO is an appropriate valuation methodology to use at all.
In conclusion, in our view, the use of ECO is improper for the purpose of valuing Realia's residential land holdings. It appears to us that the Audit and Control Committee of the Board of Directors has not taken sufficient steps to ensure the quality of the audit works and that EY has reasonably certified Realia's individual and consolidated annual accounts in accordance with its statutory and contractual duties.
We would like to remind the Audit and Control Committee of the Board of Directors that the accounts of Realia published since 2012 have used this ECO valuation method. These annual accounts have served as the basis on which shareholders have made their decisions to acquire and dispose of shares, including as part of three capital increases (in 2015, 2016 and the ongoing one in 2018) as well as two takeover bids by Inversora Carso S.A. de C.V. (in 2015 and 2016). As such, the consequences of the potentially improper use of ECO as a valuation method has affected all shareholders.
In Realia's press release of 3 December 2018, the company stated that "it is important to note that it was in 2012 when Realia adopted the ECO valuation method, a decision that was taken by another management team than the current one, which took over in 2015". Even if another management team or group of directors initially took an improper decision, it does not absolve the current members of Audit and Control Committee of the Board of Directors where the use of a valuation methodology is improper. The current members, in place since 2015 (and two of them have been members of the Board since 2007), have had many opportunities to correct this matter. We would also note that the stated rationale in 2012 for Realia changing the valuation methodology of its housebuilding activities to ECO (described as being due to "the process of negotiation to restructure the debt of its residential business with the syndicate of banks") was in any event irrelevant following the 2016 refinancing of Realia's debt.
We would welcome the substantive comments of the Audit and Control Committee of the Board of Directors of Realia, as well from EY, about this matter, within the next 7 calendar days. Pending a full and satisfactory response that properly addresses our concerns, we reserve the right to take such steps as we may be advised to take. These steps include, but are not limited to, the request for a consultation or a formal investigation by the Institute of Accounting and Auditing (Instituto de Contabilidad y Auditoría de Cuentas) into the use of ECO in the context of IFRS accounting by a publicly-listed company in the European Union, as per articles 49 and 50 of Law 22/2015, of 20 July, of Accounts Audit.
A copy of this letter has been sent to TINSA in light of the opinion they express in their Working Paper referred to previously.
We are also sending a copy to EY, in their capacity as auditors of Realia.
Polygon Global Partners LLP
Mr. Francisco V. Fernández Romero, EY
Mr. Gerardo Kuri-Kaufmann
Mr. Juan Antonio Franco
1 TINSA Research Working Paper "La valoración de inmuebles desde la perspectiva del Plan General Contable". https://www.tinsa.es/servicio-de-estudios/otros-informes/la-valoracion-de-inmuebles-a-efectos-contables/
Contact: Polygon Global Partners LLP (email@example.com)
SOURCE Polygon Global Partners LLP