Due Diligence

Just when you think most of the white-collar mischief has been brought to light in Arkansas, more stunning news arrives.

The latest development involves what is alleged to be an elaborate scheme involving fake improvement district bonds sold by Little Rock lawyer Kevin Lewis. Early indications are losses of at least $22 million that assuredly jeopardize the capitalization of First Southern Bank of Batesville, but are also likely to impact other banks and investors who bought the bogus bonds.

Details of this incident came to light just as I was reading Mark Friedman’s cover story in Arkansas Business on the bankruptcy hearing testimony of Brandon Barber, the northwest Arkansas real estate developer who milked millions of dollars from banks, friends and family to fund his penchant for high-stakes gambling and an extravagant lifestyle.

This, on the heels of revelations about felon Gene Cauley, bankrupt (and accused felon) real estate developer Steve Clary, arsonist developer and lawyer Aaron Jones and many others that Arkansas Business has chronicled during a deep recession that cast light on some really bad business practices that in most cases were enabled by willing lenders. More is yet to come.

All of which brings me to the issue of due diligence and banks.

The vast majority of the Arkansas-based banks have performed admirably through the recession. Bank of the Ozarks and First Security Bank, for example, have been recognized among the top performers in the country. Home Bancshares Inc., Simmons First National Corp. and Arvest Bank have been strong enough to be able to take over failed out-of-state institutions. Others, including those mentioned above, have taken reasonable hits on commercial and residential real estate and consumer lending that would be expected under the economic conditions.

Then there are those that took big gambles, have been victims of fraud or made assumptions based on customer reputations. Rest assured we all pay the price for these developments.

The result moving forward is a significantly higher level of due diligence, which is being demanded by regulators and embraced by bankers who now have cover to be more demanding of disclosure. Ronald Reagan’s “trust but verify” foreign policy principle serves me well with my children and would be prudent for financial institutions.

This will annoy genuinely solid, well-financed investors. Higher-level proof of incomes, appraisals and company valuations can be costly. But this is no different than what happened to the nation’s air travel. The actions of a few terrorists required vast changes for everyone.

In particular, banks have to become far more wary of limited liability companies that a borrower has a stake in. A common theme in the cases of Barber, Clary and Jones is wildly inflated valuations of certain LLCs used to dress up financial statements.

It’s also critical for lenders to demand details of ownership of the LLC or other corporate entity. Let’s say you loaned money last year to an LLC member and learn today that one of the other major members is Cauley, Clary or Barber. That contingency debt became very real.

Proof of income has to become more important, as well.

Let’s review the case of Barber. In June 2009 he claimed income of $400,000 on an application to rent an apartment in New York (moving from Arkansas to one of the most expensive locations in the world apparently is what you do right before you file for bankruptcy). Less than two months later on his Chapter 7 bankruptcy filing, he lists income of about $28,000 a year. At his hearing, he testified he was capable of earning the $400,000. In how many other applications through the years did he base numbers on capability and potential rather than reality?

Both Barber and Clary presented extraordinary net worths on paper that too many people – lenders, investors, friends – took as the gospel. The next time you feel like you’re being subjected to undue intrusions on your financial privacy – kind of like the pat downs at the nation’s airports – remember that those are among the people you can thank.

As for the Lewis bonds case, details are slowly unfolding. But the initial indications are that some banks and individuals were buying bogus bonds tied to improvement districts that don’t really exist. Those banks, especially the ones that could be crippled by the purchases and involvement, will have some serious explaining to do about their due diligence processes and lack of buyer-beware attitudes. 

Jeff Hankins can be reached via e-mail at [email protected], followed on Twitter @JeffHankins and connected with at Facebook.com/Jeff.Hankins and Linkedin.com/in/JeffHankins.