Trustees: Leaders of Affiliated Kited $475M in Checks

In the months leading up to the bankruptcy two years ago of Affiliated Foods Southwest Inc. of Little Rock, its CEO and chief financial officer were protecting their bonuses by operating a check-kiting scheme that totaled nearly half a billion dollars, according to recent lawsuits filed by Affiliated's trustees in U.S. Bankruptcy Court.

Just ahead of the trial of former CFO Alexander "Lex" Martinez, the trustees have sued the 14 members of Affiliated's board of directors for allegedly ignoring several red flags that should have alerted them to crimes that occurred from late 2008 until early 2009.

"The Board ... abdicated their responsibilities and failed to use any semblance of due diligence to discover, impede, prevent or stop the scheme," M. Randy Rice, who is the trustee for Affiliated's subsidiaries, said in a complaint filed May 4. "The total amount of this check kiting scheme was $474,800,000."

Rice's lawsuit mirrors one that Affiliated's trustee, Richard Cox of Hot Springs, filed April 18. Cox is seeking at least $40 million from the board members.

Cox also named former executive vice presidents Al Miller and Ron Rivers as defendants.

Board member Kevin Doucet of Opelousas, La., told Arkansas Business last week that he couldn't comment on the allegations because of the pending litigation.

"I can make a lot of conjecture, say a lot of things, that [should have or could have been done] because I know a lot after the fact," he said. "I'm down here in south Louisiana and we had limited access."

Other board members couldn't be reached for comment.

From the trustees' lawsuits emerges a more detailed account of the downfall of Affiliated and its subsidiaries, which was once one of Arkansas' largest private companies with reported annual revenue of $730 million in the fiscal year that ended June 30, 2008, its last full year of operation before filing for bankruptcy protection in May 2009.

At the time of the bankruptcy, Affiliated had $47.6 million in assets and $101.5 million in debt, of which $62.5 million was to unsecured creditors.

The collapse of Affiliated also has led to federal criminal charges. In February 2010, John Mills, the former CEO of Affiliated, pleaded guilty to a check-kiting charge and to aiding and abetting bank fraud. Mills, 60, was sentenced to 41 months in federal prison. At the time of his sentence, federal prosecutors said the size of the check-kiting scheme was about $11.5 million and the actual loss to U.S. Bank was about $4 million.

Few details emerged from that prosecution because Mills waived indictment and went directly to court to plead guilty.

Lex Martinez, however, is scheduled for trial May 23 in U.S. District Court in Little Rock. He is charged with check-kiting, conspiracy to commit bank fraud and aiding and abetting a false statement for giving U.S. Bank phony financial statements.

Martinez's attorney, Chuck Banks of Little Rock, said last week that he hadn't seen the lawsuits from the trustees. But he said he would vigorously defend Martinez on each of the three counts, "including any allegation that he orchestrated a check-kiting [scheme]," Banks said.

Company Rise

Affiliated Foods Southwest, which was founded in 1948, operated as a wholesale food distributor for more than 400 stores in Arkansas and surrounding states. Affiliated also owned about 45 stores, including Harvest Foods and Piggly Wiggly locations.

Jerry Davis, who had been the CEO of Affiliated for 17 years, died on Nov. 30, 2004, and Mills, who was its president and chief administrative officer, was promoted to CEO.

Within three months of Mills' promotion, Martinez was hired to manage the company's accounting department. He was promoted to CFO in June 2005.

In those early years under Mills and Martinez, Affiliated and its subsidiaries seemed to be profitable - barely.

For the fiscal year that ended June 2006, Affiliated reported net income of $4.2 million on sales of $639.3 million. A year later, Affiliated reported a profit of $3.1 million on sales of $629.4 million. But those numbers were misleading, Rice said.

‘Falsely Positive Picture'

Rice said in his court filings that receivables weren't reported correctly on the financial statements of Affiliated's subsidiaries.

"It was important that the notes receivable balance accurately reflect how much cash would ultimately be received, or in accounting terms, ‘realized,' in respect to these notes," Rice wrote. "To the extent that these current notes receivable balances were overstated, or, in accounting terms, ‘not presented at realizable value,' in the financial statements, they gave lenders a falsely positive picture of the companies' financial position."

If the board or the managers had insisted on appropriate accounting practices, Rice said, the net income for the subsidiaries would have been lower. The lawsuit doesn't say how much lower the income would have been.

In the audited financial statements of Affiliated's subsidiaries, the current notes receivable line item was $11.1 million in 2007, up from $6.2 million in 2006, Rice said.

That increased value on the financial statements made the subsidiaries appear more creditworthy than they were, Rice said.

Affiliated's managers then used those audits to get loans, Rice said in the lawsuit. "The Board, asleep at the switch, let them."

In September 2007, the subsidiaries borrowed $19 million from GE Commercial Finance Corp., but the subsidiaries couldn't service the debt. And that's when the check-kiting began, Rice alleged. And as the subsidiaries were becoming insolvent, Mills and Martinez allegedly "conspired to and did in fact commit bank fraud to cover the shortfalls," he said.

Bonuses Tied to Revenue

Cox said in his lawsuit that Mills and Martinez cooked up the check-kiting scheme to disguise the financial health of Affiliated and to keep the company limping along as long as possible. Cox blamed the board's policy of awarding bonuses based on revenue rather than profit.

The lawsuits don't indicate how much Mills and Martinez were paid or the size of their bonuses.

"This pay structure motivated Mills and Martinez to operate AFS in a fashion to increase revenue, or at least create the appearance of increased revenue," Cox said.

Affiliated's stores were kept open "even if the stores were bleeding money, because closing the stores would have reduced management bonuses," Rice said in the lawsuit.

The board never changed the policy of bonuses being tied to revenue.

What Audit?

As the financial crisis was mounting inside Affiliated, the board of directors never received an audited financial statement for the fiscal year that ended June 30, 2008.

Cox said the financial strain could have been detected if directors had demanded an audit, as had been provided in the past. Instead, board members relied on management's pro forma draft, "which inaccurately presented the company's bleak financial condition, or relied on no financial data regarding AFS," Cox said.

The board "failed to ask questions or demand an explanation for the missing information," Cox said.

Meanwhile, Affiliated's financial problems were getting worse. For the three-month period that ended Sept. 20, 2008, Affiliated had a loss of $6.2 million, Rice said.

The loss itself violated the terms of Affiliated's $70 million line of credit with U.S. Bank, to which the company reported weekly. In order to avoid a technical default on its debt, Mills and Martinez told U.S. Bank that Affiliated had a net income for that first quarter of $401,000, Rice said.

On Sept. 29, 2008, Mills - and allegedly Martinez - began kiting checks.

Relying on the ‘Float'

Mills and Martinez allegedly developed a check-kiting scheme using checking accounts of Affiliated's related companies Supermarket Investors Inc. and Convenience Store Supply Inc., Cox said.

The alleged check-kiting scheme worked like this:

Martinez would hand-deliver to Mills the daily cash needs report, which had been prepared by an Affiliated accountant showing the cash shortfall based on the anticipated deposits versus the anticipated clearing items.

Mills and Martinez would then discuss the numbers. Martinez allegedly would then instruct Affiliated accountants to cut checks from Supermarket Investors and Convenience Store Supply for the amounts needed to cover the anticipated cash shortfall.

Those internal accountants - the lawsuit didn't say exactly how many - are identified only as "John Does" in the lawsuits.

The kited checks had to be prepared quickly and deposited before 2 p.m. so Affiliated could obtain same-day credit.

Then the Affiliated deposits were withdrawn by U.S. Bank in a process known as sweeping the account and used to lower the outstanding balance on Affiliated's line of credit, Cox said.

"By including the kited checks to artificially reduce their outstanding credit line balance, AFS was then allowed to withdraw more money from its line of credit than it would have been allowed to had the kited checks not been deposited," Cox said.

The additional money kept other checks to creditors from bouncing, Cox said.

"This resulted in a one-day float of additional cash," Cox said. "The following day AFS drew funds from the line of credit and deposited those funds in CSSI and SII's account to cover those checks kited the previous day. Then, new kited checks were issued by CSSI and SII based on that day's cash needs."

It is unclear how Mills and Martinez hoped to stop the check-kiting scheme once it was set in motion. The size of the kiting steadily increased as the scheme continued.

From Sept. 29 through Nov. 21 of 2008, the amount of checks kited usually was between $1 million and less than $3 million per business day. But after Dec. 3, 2008, the daily amount kited never fell below $4 million per business day.

The daily amount reached $10.3 million on Feb. 25, 2009, and then $11.6 million on Feb. 26, 2009 - huge numbers for a company that had net income of $7.3 million for 2006 and 2007 combined.

On Feb. 27, 2009, U.S. Bank discovered that Affiliated was overdrawn by more than $11 million and declined to honor more credit requests.

The board should have known that the subsidiaries didn't have the money in their bank accounts to cover the checks to Affiliated, "but nevertheless close to half a billion dollars in insufficient checks were being written on these accounts to perpetrate this massive check kiting scheme," Cox said.

"We did trust them a lot," Doucet, the board member, told Arkansas Business last week.

By that time it was too late for Affiliated.

"Unable to secure credit, AFS's inventories declined drastically and it lost a number of key customer relationships," Cox said.

In early March 2009, in the first public sign of trouble, Mills was removed as CEO.

The company filed for bankruptcy on May 5, 2009 and stopped operating on July 19, 2009.

At his sentencing hearing in October, Mills told U.S. District Judge Leon Holmes, "I'm very sorry to have got caught up in this, and I regret that what I did was illegal. I don't have any excuses."

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