The Role of Attorneys Following a Fraud Is Examined
by Robert D. Katz, Managing Director, Executive Sounding Board Associates Inc.
For the purposes of this article, consider the history and recent business practices of a company we’ll call JKL Shoes. JKL, a privately-held company, is a well-established, family-owned women’s footwear manufacturer. Consider these facts:
Owned and operated by the second generation, the company enjoyed for many years a strong record of success. In recent years, the business generated revenues of $75 million and had a reputation within the industry for superior technical expertise. Its clients were largely comprised of solid Fortune 1000 companies.
The company had a $10 million secured asset-based line of credit. This included $6 million for machinery and equipment purchases and about $3 million of secured real estate debt. With regard to collateral, accounts receivables were $10 million—of which $8 million were eligible. The advance rate was 80 percent. Total finished goods inventory was $7 million, of which $6 million were eligible. The advance rate was 50 percent. There were no personal guarantees.
Historically, the company had been profitable—until recently. It had been considered one of the most profitable companies in the manufacture of low-end women’s shoes and sandals. However, beginning two years ago, the company began to show sustained losses and reduced cash flow. At the same time, family members were shown to have noticeably increased their “all-in” compensation. In 2002, the financial statements were audited.
A year later, revenues at JKL Shoes fell off about 5 percent to $71 million. The collateral and availability, however, were reported to have remained consistent. Meanwhile, accounts receivable dropped by 5 percent, although eligible accounts receivable remained consistent, as did inventory. UCC’s and other related information had all been properly filed and/or processed.
The lender’s auditor felt something was amiss. In his periodic report, he questioned how the collateral levels had remained consistent and the owners had raised their compensation, while sales, profits and cash flow had all decreased. He also noticed what appeared to be less equipment in the building compared to what was listed. In performing test counts on the inventory, he also became aware of some minor discrepancies.
Based on the auditor’s concerns, the lender met with the owners of JKL. A second meeting was scheduled to discuss a plan to turn around the company and shore up its collateral, operating position, and address covenant issues, in light of the losses.
At this meeting, the lender came away with the conclusion that the borrowing base and collateral weren’t “quite right.” More specifically, they heard that:
- Eligible accounts receivable had been overstated by $1.5 million.
- Eligible inventory was inflated by $750,000.
- $400,000 worth of equipment had been sold, with the proceeds not turned over to the bank as required by the loan agreement.
- The company’s financial statements may have been impacted.
Specifically, the lender concluded that accounts receivable may have been overstated due to the premature recognition of revenue perpetrated near year-end. The company had sold product on a “bill and hold” basis, recognizing revenue and accounts receivables before the goods were shipped. The “bill and hold” goods were specifically “ineligible” and the recording of the “sale” did not comply with the GAAP. The company recognized revenue and recorded accounts receivable upon shipment of shoes when the terms of the “sales” were FOB destination, and on “sales” to existing customers who had not requested the goods and returned them the following quarter.
Despite the fraudulent practices, the company continued to show reasonable prospects for the future. JKL’s true sales backlog increased for the first time in three years. The company had developed a new type of shoe that appeared to have great promise in the marketplace. Additionally, the owners pledged to offer some sort of personal guarantees to the lender.
The Role of the Attorney
What’s the role of the attorney representing a client like JKL Shoes?
It begins by identifying which executives and board members were involved in the fraud. Was it everybody? Were some unaware? And, if so, why? If somebody indicated they were unaware, it is critical to understand why. After all, what does it say about them?
The attorney must work closely with the turnaround consultant to follow the trail of the fraud. It’s recommended that the attorney have the consultant conduct the snooping with respect to any concerns about privileged information.
The attorney needs to be prepared to ask the client and their management the tough questions to determine whether there are any executives worth salvaging. Consider the following points:
- Even a fraud perpetrated without the involvement of the CEO or executive committee raises grave questions. The perception among many is that fraud should not happen under one’s watch—regardless of the circumstances.
- If there is any perception of impropriety, people will shy away from doing business with the company. For the attorney, working closely with the consultant involves more than simply interviewing senior management. The attorney has to determine just how deep and quick the cancer (i.e., fraud) spread. This means drilling down to lower-ranking employees who may have less to lose and so may offer a more accurate portrayal of the circumstances surrounding the fraud. In my travels, I’ve often found that you can learn as much from a person on the loading dock as you can from someone in the executive suite.
Corporate Governance
In identifying and implementing appropriate corporate governance controls moving forward, the need often arises to separate the titles of CEO/President and Chairman, and to create a more independent board of trustees (even in the case of a private company). After fraud has been discovered, the more separation of duties and controls the better. It is one of the quickest ways to restore credibility.
An independent board will provide support and leadership to a company like JKL moving forward—from both a practical and, as importantly, a public relations perspective. A board stacked with CEO cronies, including management toadies, best friends, brothers-in-laws, backslappers and next-door neighbors gives the appearance of “business as usual,” as does a plethora of board members with fat consulting contracts or with a “cross board” mentality (i.e., you sit on my board and I sit on yours).
Subsequent to fraud, excellent and well-implemented corporate governance procedures can play an important role in not only the continuing life of any entity, but in beginning to re-establish credibility. Private companies need to have boards that—as with public enterprises mandated by laws like Sarbanes–Oxley—identify weaknesses in compliance, fix them and maintain an ongoing assessment. It creates a competitive advantage and enhances a company’s reputation and investor confidence. An attorney can assist a company in assembling such board members to provide the insight and stability needed in this type of situation.
In addition to establishing new procedures and identifying new independent board members, part of revamping and resuscitating corporate governance includes establishing audit and compensation committees with meaningful review and implementation authority. While size may be one of the factors to consider, the company must prove that it has cleaned up its act and is serious about enforcement and subsequent improvement. In short, it must show that it just wasn’t done for appearance sake alone.
The attorney’s role is not to do a tap dance or a soft shoe, but to show that the client has cleaned house and put proper controls in place. Out-of-the-box thinking and the ability to handle pressure and provide guidance are critical to laying the foundation for your client’s turnaround.
Lawsuits
All carriers must be placed on notice immediately after a fraud. Consider:
- Who is likely to bring claims?
- Who is likely to be sued?
- Can your client sue?
The attorney needs to consider the likelihood that someone will sue and so must assess the exposure and work to quantify the magnitude of damages. A competent attorney needs to put his client in a position to be able to defend claims and prepare for the future. As a result, he or she must be capable of defending whatever claims come forward.
Similarly, the client may have claims of its own. Is there any culpable party that should have known about the fraud? Investigate the Director’s and Officers insurance policy or the Errors and Omissions policy. The attorney must be prepared to think creatively in order to assess opportunities for the client to potentially recover damages as well.
Restructuring
Is there a realistic prospect of saving the business without going through the bankruptcy courts? If so, is the current lender prepared to support and provide continuous funding? And, if so, at what cost? If the attorney has a relationship with the lender, there may be the opportunity to facilitate a reconciliation. Anecdotally, we once worked with a client that perpetrated a $7 million fraud on the lender. You have never seen $7 million swept away so quickly. The client explained that they had just debited purchases and credited accrued expenses with a wave of a hand.
As the consultant for the debtor, we came in with the attorney to assess and assist the business. We were able to show that the offenders had been removed and the business fundamentals were still in place, convincing the lender that it would be worthwhile to stay in since this offered the lender the best prospect of payment. We restructured the debt so the lender was paid fully two years later. Having said that, certain lenders, when they become aware of the fraud, are more inclined to shut the business down regardless of their loss or potential exposure. Regardless, it is important to understand the new dynamics in the relationship.
Gaining alternative financing can be difficult for a company that has lost its lender after a fraud. Simply put, no one wants to finance a crook. It may come down to the client’s willingness to provide personal guarantees, additional support and collateral (as in the case of JKL Shoes). With sufficient collateral, someone may agree to lend money—although it most likely will require significant monitoring and be very costly and expensive both in time and funds.
There are numerous reasons that people commit fraud. Most attorneys will find that their client committed fraud because they found themselves in a desperate situation or became greedy. In most cases, as a result, it’s unlikely the business will have much collateral. In the case where the attorney and/or consultant have cleaned house by firing the existing management and executive team, there is a better chance. Still, the chances for survival may not be great. Very often, lenders and other constituencies look to see if the business fundamentals are in place and if they have confidence in the new group of people operating, guiding and setting the strategy for the business. It is important to determine whether the lender can separate the past fraud from the future prospects of the business and whether there is additional collateral to support the restructuring. The same factors come into play for selling or exiting the company. There is more money in the marketplace than ever before. If the fraud occurred because of executive greed—and the guilty parties and those asleep at the wheel have been removed—the chances for unloading the company increase exponentially. Attorneys can often play a key role as a result of their relationships with investment bankers, equity funds, consultants, etc., or at their partners’ contacts or network base. Clients expect their attorneys to have the resources and contacts to bring people to the table.
The Bankruptcy
Should the company be forced into bankruptcy, the primary questions for the attorney need to be:
- What are the direction, strategy and timetable you plan to follow?
- What is the desired outcome?
- Is it consistent among all or most of the constituents?
- How quickly can it be achieved?
The goals are very different following a fraud than a general bankruptcy filing. The business may have been sound, only the owners were pigs. The attorney must work with other professionals, including the lender and its attorney, to see about restructuring the business or selling off the assets. The attorney must have a vision going into the restructuring and be capable of understanding the business from both a short- and long-term perspective (if there is one).
The client should consider hiring a Chief Restructuring Officer (CRO) to give an appraisal of the business’s potential and strategies to maximize it. Information provided by a credible source, like the CRO, may allow the attorney to structure a better deal. For example, if the business will be able to generate cash, say, within the next four months, the attorney will be able to structure a different deal and achieve different results than if the business will not be profitable for three years.
Any bankruptcy attorney needs to be cognizant if the client has reached the zone of insolvency and if fiduciary duties are now owed primarily to vendors and creditors.
Finally, attorneys must be aware of their ethical duties when representing clients that have been parties to a fraud. Experienced attorneys realize they could become the target of lawsuits. They also understand the requirements and expectations of regulatory bodies and agencies like the FBI or the state bar association.
Attorney for the Lender
What are the considerations for your client the lender?
The attorney for the lender obviously has to evaluate similar circumstances, but usually with different considerations and objectives. It almost goes without saying that fraud means covenants are in violation and the loan is in default.
Having said that, the attorney needs to consider the following possibilities:
- Do you call the loans?
- Is foreclosing on collateral a desirable option?
It all begins with understanding the client’s objectives, helping it to determine the best course of action, and assisting in achieving it. As mentioned above, for some lenders the minute they hear about a fraud, they pull the plug regardless of the potential recovery. However, some are prepared to work with the company.
An experienced and seasoned attorney can help the lender recover significant sums, reduce their exposure and become a hero to their client. Nothing will help provide a larger, better and longer lasting impression than helping a client recover their loan from a fraudulent borrower when all hope seemed lost.
The attorney also must help the lender manage its exposure, so the lender doesn’t become a party to managing the business and face lender liability issues or having the lender’s claims subordinated in a bankruptcy. This may include:
- Caution against promises to forbear to extend new credit in exchange for the company’s cooperation and accession to the lender’s demands.
- Making any representations about the health or viability of the company to any third party, creditor or vendor.
- Exercising restraint in terms of the extent of involvement in the management and operation of the company—either exercising too much control or dictating corporate policy.
If the lender’s decision is to keep the company afloat in order to get paid, trade creditors may argue they were induced to provide credit solely to improve the lender’s collateral position. Should the company be sold? The attorney must assess the risks and benefits of a sale in or out of bankruptcy. The following considerations must also be addressed:
- Do you sell the company in bankruptcy and get rid of the liabilities?
- Do you keep it as a stand-alone, ongoing business?
- Do you sell it outside of bankruptcy so as not to anger trade creditors?
- Are there rapidly deteriorating assets that won’t maintain value in a bankruptcy?
It all comes down to having a game plan in hand and a shared vision in mind.
Remember, whether the client is a debtor or secured or unsecured creditor, understanding their goals and objectives is critical to both the attorney and to the hope of achieving success. Clients who achieve success attributable to the attorney’s advice will ultimately bring a trail of more engagements… and more successes!