Fair Finance: Trust The Accountants, Not The Attorneys

As an attorney by profession, it pains me to say this, but my review of the complaint the bankruptcy trustee for Fair Finance filed against the affiliated companies owned and controlled by Ponzi scheme operator Tim Durham to recover a small part of the more than $200 million lost by small Ohio investors in the company leads me to the conclusion that you should listen more to your accountants and not your attorneys, at least in this case. Reacting to the 49-page complaint Trustee Brian Bash filed against Durham's Obsidian Enterprises and Diamond Investments, Durham's attorney is claiming Bash got it all wrong in suggesting Durham looted the company and used the money the Ohio investors loaned to it no differently than your classic Ponzi scheme. The Akron Beacon-Journal's Jim Mackinnon shares the reaction of the Ponzi scheme operator's attorney:

''I think at the end of the day we'll demonstrate the trustee was wrong,'' said Dennis Concilla, lawyer with Columbus firm Carlile Patchen & Murphy, which represents Durham, Cochran, Obsidian Enterprises and DC Investments.


Concilla said he expects to file a formal answer to the lawsuit in 20 to 30 days.

It is ''disingenuous'' of the trustee to say Durham and Cochran took Fair Finance money for personal use, he said. Because Fair Finance was a private company and not publicly traded, ''they were entitled to use that money,'' he said.

''We also believe categorically it was not a Ponzi scheme. It was real investments made in real companies,'' Concilla said.

Concilla has obviously not taken a very close look at what Durham's accountants told him nearly six years ago about their concerns Fair Finance was beginning to look too much like a Ponzi scheme. An April 5, 2005 letter to Durham and his business partner, Jim Cochran, the accountng firm of BGPC went to great pains to explain to the men why their accounting firm would not certify the financial reports for the company for 2003 or thereafter. "We believe the Company is at a crucial stage and continuing actions need to be taken to address the financial and other risks outstanding to protect FHI and Subsidiary as a long-term operating entity."

Concilla's suggestion that because Fair Finance was a private company, Durham and Cochran could use the company's money as they pleased, even if for personal use, defies common sense. If there were no safeguards under the applicable Ohio laws under which these debt offerings were being made available to Ohio investors under an intrastate exemption from security registration requirements, then why were their debt offerings even subject to approval of Ohio regulators? BGPC acknowledged in its letter that Durham had obtained an opinion letter from Indianapolis attorneys at Riley Bennett & Egloff for its exemption to issue the debt offering to investors in Ohio, but it urged the two men to seek further opinion of counsel on "compliance with other facets of Ohio securities law or, at a minimum, consult with counsel as to whether there may be areas of the law that could create a potential issue based on the lending practices at FHI and the significant lending to related parties."

First and foremost among BGPC's concerns was the significant loans Fair had made to the related companies controlled by Durham, and the fact that most of those companies had a negative cash position. More troubling to the accountants were the reckless manner in which these loans were approved and managed. Fair recognized interest income on all of its loans regardless of whether any interest was being paid on them and without maintaining loss reserves for bad loans. The company in fact had no policy for placing a loan on a non accrual basis because of the deteriorating business condition of the borrower evidenced by no payments within terms and collateral-dependent loans. The company had no policy for monitoring the credit status of any of its borrowers. The large related loans made to Obsidian, in particular, raised serious concerns to the accountants because of its negative operating results and its going concern issues. [W]ithout the support of FHI, the Obsidian group may not have been able to continue in its current form," BGPC suggested.

The related-party loans were too challenging from an accounting and documentation standpoint for BGPC. By definition, these were "not arm's length transactions and should not be presumed to be representative of a transaction that would be entered into by unrelated third parties." BGPC observed these loans often required no payment until maturity, frequent changes in loan terms, insufficient or nonstandard collateral and no monitoring--all "strong indicators of transactions that are not at arm's length." BGPC pointed out that loan guarantees for Obsidian's debts were made by Durham and Cochran, who also provided significant personal assets as collateral to Fair. "Should the guarantees on the Obsidian debt be acted on by the lenders, the collateral to FHI would be at risk."

Laying all of that aside, Concilla apparently never learned anything about fiduciary duty in law school. This point did not go missing on accountants at BGPC. "The Board of Directors of FHI should question whether there is a fiduciary responsibility of the owners, officers and directors of [Fair] to the holders of [Fair's] subordinated investment certificates," BGPC pondered. "We are not in a position to render an opinion on this matter, but consider it to be a relevant question based on the lack of controls in place, nature and materiality of related-party lending practices, and potential for material impact to the Company should this matter apply." "Accordingly, we strongly encourage to engage outside counsel competent in these matters to provide a legal opinion regarding such items," a pointed reference suggesting the accountants strongly believed Fair was not receiving competent legal advice.

To be fair, communications between other accountants and attorneys questioned the professional services of other professionals according to exhibits attached to the trustees complaint. The accounting firm of BDO was highly critical of Somerset for taking on Durham's Obsidian as a client. An accountant for BDO wrote in an e-mail to another colleague after seeing a Form 8-K prepared by Somerset for Obsidian, "We were doing the audit of a related party (Fair Finance) that at first was clean. Then it became a problem and we resigned." "Somerset took that one also." "These companies have serious issues." "Somerset just issued a clean opinion on Fair." "There is no way that should have been clean." He added, "If Somerset brings any of this to BDO you will not want any part of it."

While the law firm of Riley Bennett & Egloff earlier (in 2005) may have been comfortable that Fair Finance's offerings qualified for the intrastate exemption from securities registration, another attorney in Ohio's view on the exemption's safe harbor evolved as the business practices of Fair changed dramatically under Durham's ownership of the company. The SEC, according to Ronald Kaffen of Hardesty, Kaffen & Zimmerman, supported the exemption for Fair's traditional business because the company physically retained its collateral in Ohio and at least 80% of its dealings involved the purchase and collection of receivables occurring in Ohio. In a letter written a little more than a year before the FBI raided Fair's offices, Kaffen wrote in an e-mail to Durham that he originally thought the loans made to Fair Holdings, also an Ohio company, were for the purpose of entering other markets different from its core business of purchasing and collecting receivables. Kaffen didn't realize Fair intended to supplant nearly all of its core business with these new markets. Eventually, the company had jettisoned most of its receivable business and primarily needed to issue new investment certificates simply to retire maturing debt obligations. Kaffen characterized the new way of doing business as nothing more than a "pyramid scheme."

What funds raised from certificates to retire maturing certificates was overwhelmingly being used to provide loans to related companies outside of Ohio Kaffen observed. "If this is truly the purpose of more than 20% of the offering, the exemption is no longer available," Kaffen opined. Kaffen worried that the economy was headed into a sustained recession and the ability to renew outstanding certificates would put financial pressure on the company. In the event the company was forced to restrict payouts at maturity, Kaffen worried about investors filing lawsuits against the company. The plaintiffs would argue Fair had issued unregistered securities Kaffen stated. "If the argument is successful, there will be personal liability for all of the directors and executive officers of the company." He added, "Of course, my firm would also be joined and I would be faced with the same liability." Kaffen told Durham he did not claim knowledge of his "overall business strategies and the interrelation of Fair with your other holding." "All that I know is that Fair cannot obtain an audited financial statement due to the interlocking ownership of other businesses."

Durham's reply e-mail to Kaffen's lengthy discussion was very telling. "There are many ways to interpret this." I have always looked at it this way." "Every month we issue new certs and retire old certs." "The excess is really what you are talking about." "But in reality, 90% of all new sales retires old certs and interest thereon." "I have always viewed it that way. Otherwise almost all of our receivables are generated out of state and always have been." If Durham would listen to himself talk, he would understand he is describing a business that operates like a classic Ponzi scheme. When Kaffen restated his concerns in a second lengthy e-mail, Durham's response was, "I am not sure I agree with your logic but I also thought we restructured everything to make sure we comply."