The Commercial Fraud Task Force Committee held a meeting at the ABI Winter Leadership Conference on Friday, Dec. 7, 2007. Co-chair Frank Monaco, introduced his fellow co-chairs, Jack Seward and Sheryl Toby. The meeting was well attended and followed by a joint presentation of the Commercial Fraud Task Force and Bankruptcy Litigation Committees.
Moderator Frank Monaco introduced the members of the panel and provided a brief outline on the program presentation: a mock hearing to approve the appointment of a chapter 11 trustee, or in the alternative, an examiner. Hon. Barry Russell (C.D. Calif.) presided. The panelists included Diana Adams (U.S. Trustee for Region 2) as the U.S. Trustee movant. Jordan Siev, formerly at Anderson Kill & Olick and now with Reed Smith, represented the unofficial creditors committee and also supported the motion, which was opposed by the debtor, represented by Brian Walsh (Bryan Cave). Joining in the opposition was Deirdre A. Martini, formerly at CIT Group and now managing director at Wachovia Capital Finance, representing the official committee of unsecured creditors (which is dominated by holders of commercial paper). Dramatic testimony was offered by Cyrus Pardiwala, U.S. restructuring advisory services leader and partner of PricewaterhouseCoopers LLP, who portrayed the witnesses for both sides as well as the CPA for the moving party seeking the trustee and also the evil twin CPA for the debtor seeking to remain in possession. The case was loosely based on the New Century Financial case, and the presentation was well-received by all attendees.
Factual Background of the Mock Hearing[1]
Financial Supermarket Inc. (FSI) is a roll-up of various businesses in the financial industry. Its founder and CEO, Eddie “No Money Down” Johnson, built the company through acquisitions over the past five years. FSI conducted an initial public offering of its stock 18 months ago, at which point Johnson’s ownership interest in the company was reduced to 10 percent. At the time of its chapter 11 filing last month, FSI’s operations included a subprime mortgage lender and servicer, a chain of upscale pawnshops in major cities, a factoring company specializing in the receivables of Chinese toy manufacturers, a finance company with a portfolio of loans to plaintiffs’ lawyers secured by potential contingency fees in silicosis lawsuits, and a qualified intermediary providing custodial services to parties conducting like-kind exchanges under §1031 of the Tax Code of environmentally contaminated properties.
FSI’s bankruptcy filing was prompted by several factors. First, the company announced two months ago that it was restating two years’ worth of financial statements. According to FSI’s press releases and filings with the Securities and Exchange Commission, certain employees in FSI’s accounting department made inaccurate entries in the company’s books over a two-year period. The restated financials reflected net income that was approximately 50 percent lower than in the original financial statements. FSI promptly terminated the employees directly responsible for the misstatements, but its controller and chief financial officer remain with the company. FSI also engaged a Big Four accounting firm to investigate and to report to the company’s audit committee about improving its internal controls. That firm has not completed its investigation. In the meantime, a prominent financial newspaper has reported that the CFO was involved in the misstatements and suggested that Johnson was at least aware of them. The newspaper did not identify its sources.
Second, FSI made substantial loans to NMD Productions LLC, a company owned by Johnson. NMD has invested in several feature films and documentary projects, but none are expected to be ready for theatrical release before 2010, and the loans will not produce cash flow for FSI before that time. Johnson and NMD claim that these loans—which totaled approximately $50 million at the time of the bankruptcy filing—were properly authorized by FSI and its board of directors. Several members of the board were quoted in the newspaper article mentioned above as saying that they’ve never heard of NMD. The loans were disclosed in FSI’s audited financial statements, but Johnson’s ownership of NMD was not.
Finally, conditions in the economy generally and in FSI’s industries in particular have resulted in a liquidity crunch. Among other things, FSI relied heavily on securitization of its mortgages and issued substantial amounts of commercial paper to fund its retail operations, and these sources of funding essentially disappeared.
Prior to bankruptcy, FSI’s board of directors consisted of eleven members, including Johnson, the CFO, the COO and the president of the company, plus seven outside directors. Most of the outside directors were asked to serve by Johnson as the company prepared for its IPO, although two of the seven joined the board after the company went public. An independent director serves as chairman of the board, and the audit and compensation committees consist only of independent directors. As FSI prepared for bankruptcy, Johnson and the CFO jointly interviewed financial advisory firms that were recommended by other board members and by FSI’s bankruptcy counsel. They eventually recommended to the board that the company retain Robert Righteous of Phig, Leaf & Co. as CRO. The board approved the recommendation unanimously, with Johnson and the CFO abstaining, and directed the company’s counsel to enter into an engagement letter with Righteous. That letter, which was executed two days before the bankruptcy filing, provides that Righteous will have the sole authority to manage FSI until the effective date of a plan of reorganization. Each of the company’s officers and directors countersigned the engagement letter. Although Righteous has the power to fire the officers, he has chosen for now to keep them on the payroll reporting to him because of their substantial experience with FSI’s business and the industries in which it operates. The directors have not met since the engagement letter was signed.
FSI is a party to lawsuits in a number of jurisdictions. Several plaintiffs have filed class actions against the company arising out of its mortgage lending and other operations. After the financial restatement, other plaintiffs filed class actions under the securities laws against the company and its officers and directors. Derivative lawsuits against the officers and directors are pending in federal and state courts and involve claims of breach of fiduciary duty, fraud and gross mismanagement. Newspapers also have reported that current and former FSI employees have been seen entering and leaving a federal courthouse in Johnson’s home town, where a crusading U.S. attorney is believed to be conducting a grand-jury investigation into FSI’s compliance with the Pawnshop Proprietors’ Proscribed Policies and Procedures Act of 1997.
Two days after FSI filed for bankruptcy protection, the U.S. Trustee filed a motion for the appointment of a trustee (or alternatively an examiner). The debtor and the official committee of unsecured creditors (which is dominated by holders of commercial paper) oppose the motion. An unofficial committee of trade creditors and mortgage-industry players supports the U.S. Trustee’s position. No equity committee has been appointed at this point in the case.
The Hearing on the Motion
After the parties made opening arguments, the U.S. Trustee presented its case in support of the motion. The U.S. Trustee relied on the SEC filings, the debtor’s press releases, copies of the complaints filed against the debtor, its officers and directors and finally newspaper reports. The unofficial creditors’ committee presented testimony of its accountant, based on a preliminary review of discovery materials. He testified that the quality of internal controls was open to question, and the controller, who was a good friend of Johnson, was in charge of accounting. Furthermore, the documentation of the NMD Loans was insufficient. Hotline calls implicated Johnson and the CFO in various misstatements. He was then subjected to the cross examination by the debtor and the official creditors’ committee attorneys.
The debtor then presented the testimony of Righteous. His understanding was that he had full management power and fiduciary duty. He also believed that Johnson and the CFO had substantial institutional knowledge valuable to the debtor and its estate for at least the time being. The debtor faces difficult economic and market conditions and continuity of personnel. Furthermore, his firm has had decades of experience with turnarounds and bankruptcies including cases involving allegations of significant fraud. The testimony of a Big Four accountant hired by the audit committee was also presented. The accountant testified that an investigation was currently ongoing; there was no evidence to date that anyone other than terminating employees was involved or aware of misstatements; hotline callers had been unwilling to be interviewed or allowed their names to be used; and internal controls may have been weak during the period of misstatements but have been strengthened since that time.
Judge Russell, in a well-reasoned opinion, ruled in favor of the movants and appointed a trustee. Judge Russell stated that although it was a difficult decision, he was erring on the side of caution in appointing a trustee given the allegations of accounting fraud and mismanagement. After the conclusion of the hearing, the floor was opened to questions from the audience as well as Frank Monaco, the moderator. The presentation went well and the panelists received numerous accolades from the audience.
[1]The underlying factual background for the FSI case was developed as a collaborative effort by the panelist, moderator and committee co-chairs.