How Deloitte audit row caused a run on Chase Bank

Sharp differences between senior managers of Chase Bank and auditing firm Deloitte on how to handle assets in the lender’s possession under the Islamic banking window triggered a rapid-fire series of events that led to the bank’s collapse.

The Business Daily has reliably learned that the outcome of the two-week audit row is what pushed the SME-focused bank over the cliff, leading to its closure on April 7.

Chase Bank found itself in a tight position after the Central Bank of Kenya (CBK) directed it to restate its financial results to show the significant changes in its insider lending position that arose from the differences over the method of accounting for the lender’s Islamic banking assets.

Chase Bank’s restated figures showed it had under-reported insider loans by a whopping Sh8 billion, casting doubts over the financial health of the lender, which also reported a surprise Sh743 million loss.

The bank’s former group managing director, Duncan Kabui, last week told criminal investigators that Deloitte was yet to complete its audit of the bank and submit a report to the board as is standard practice when the restated financial results were published on April 6.

“The final audit report does not exist and has not been completed. The bank’s auditors have not submitted the audit report to the board’s audit and risk committee for discussion and approval and to the full board as is practice,” Mr Kabui told investigators — raising questions as to the basis of the CBK’s action against the bank.

READ: Detectives to question Deloitte, CBK officials on bank fraud

The CBK moved in to take charge of Chase Bank last Thursday — a day after Mr Kabui and Zafrullah Khan, the bank’s chairman, were forced out following revelations of massive irregular insider lending that precipitated a run on the bank.

READ: Chase Bank chairman and MD step aside over credibility of financials

The CBK said Chase Bank had experienced liquidity difficulties that rendered it incapable of meeting its financial obligations on April 6.

READ: CBK denied Chase Bank lender life support before collapse

Mr Kabui says in his statement to the police that the so-called insider loans were assets held in Chase Iman’s joint ventures financed under Musharakah – a sharia-compliant investment platform where partners are entitled to a share of profits in a ratio that is mutually agreed.

Mr Kabui says it was Deloitte’s about-turn on how to treat those assets that led to their classification as insider loans that caused panic in the market and led to massive withdrawal of deposits that ultimately sunk the bank.

An exchange of emails between Chase Bank executives and Deloitte shows that sharp differences emerged over the classification of assets from Chase Bank’s Islamic window.

“During the course of the audit and inexplicably the auditor changed his interpretation of these assets to loans to related parties. The auditor claimed lack of technical capacity to understand Islamic contracts yet it had been handling the bank for more than 18 years,” said Mr Kabui.

An earlier draft of Chase Bank’s financials prepared by Deloitte shows that the disputed Sh7.9 billion was classified as ‘other assets and interest receivable’ in the balance sheet only to emerge in the restated financial statement as loans advanced to an unnamed director and associated companies.

The exchange of emails show that Fredrick Aloo, an audit partner at Deloitte in charge of Chase Bank’s account, surprised the bank’s executives with his demand that the Islamic assets held in special purpose vehicles (SPVs) be charged for purposes of proper accounting.

Chase Bank, responding through its head of legal, Sevastone Makanda, warned of the danger of charging the assets, saying the action would turn them into loans that would then have to be provided for.

Mr Makanda further warned that registering a charge on the properties and turning into loans would run afoul of Islamic financing.

“The bank will become a lender and the special purpose vehicles (SPVs) borrowers obligated to make monthly repayments plus interest which will be in breach of the existing obligations, ownership,” Mr Makanda said in an email dated March 14, 2016.

Mr Aloo rejected Mr Makanda’s proposals through an email dated March 24, 2016, insisting that he had sought independent counsel from a lawyer and a banker and that he had come to the conclusion that the proposed trust deed for the SPVs would not suffice.

Mr Makanda had proposed that Chase Bank creates long-term leases over the properties receiving sharia-compliant financing as a strategy to register the bank’s interests.

The list of assets held under the SPVs included a business park in Karen, a three-acre parking lot in Nairobi, some 240 acres of land on Mombasa Road, a three-acre plot next to the German Embassy in Riverside Drive and various properties in Dubai.

Mr Kabui told the police that he did not understand the auditor’s sudden demand for a change in treatment of the Islamic assets insisting that they were fully charged to the bank.

“Even in this auditor’s midway change of accounting treatment, the properties were either fully charged to the bank or pending charging where the new titles were being processed,” he said.

Deloitte’s statement of account, dated March 16, 2016, shows the auditors had suppressed Chase Bank’s loan loss provisions at Sh527 million, resulting in a net profit of Sh2.6 billion.

But after the change in treatment of the Islamic assets, Chase Bank was forced to increase its loan impairment costs nearly threefold to Sh2.09 billion from Sh757 million in 2014, a move that wiped out the lender’s earnings.

Deloitte did not respond to questions on its audit actions citing customer confidentiality rules and that the responses may prejudice ongoing investigations.

“The matter is under investigation and therefore we cannot comment on this. We are bound by client confidentiality and therefore we cannot respond to this,” said Sammy Onyango, the chief executive at Deloitte East Africa.

Mr Kabui disclosed that the SPVs, where he is a director, were formed to capture the letter and spirit of Musharakah and that he only held the position in trust for the bank.

“It is not true that I advanced to myself the said loans as these were mere auditor-induced adjustments from previous years when they treated the properties correctly as investments,” he said.

Dr Njoroge last week said the Sh7.9 billion associated with the Islamic assets were irregularly lent to an unnamed Chase Bank director, raising questions as to the regulator’s dealings with commercial banks that are licensed to offer Islamic products.

It was the disagreement over the treatment of Islamic assets that saw Deloitte make a U-turn to issue Chase Bank a qualified audit opinion and a surprise full-year loss from an earlier unqualified position where the lender was in the profit zone.

The restatement of the financial results was done in response to the CBK directive that set in motion a chain reaction that finally resulted in a run on the bank.

“The errors noted were there was no mention of a bank’s auditors and whether the auditors issued a qualified or unqualified opinion,” said CBK director of bank supervision Gerald Nyaoma in a leaked letter dated April 4, 2016.

“The purpose of this letter therefore is to direct the institution (Chase Bank) to republish its audited financial statements and disclosures as at December 31, 2015.”

Chase Bank established Chase Iman in May 2009 to offer a bouquet of Islamic banking products and had since built a rich portfolio of properties to service it.