More than two-and-a-half years after former Little Rock attorney Kevin Lewis was sentenced to 10 years in federal prison for bank fraud, the Federal Deposit Insurance Corp. continues to clean up his mess.
Acting as the receiver for First Southern Bank in Batesville, which was shut down in December 2010 as a result of Lewis’ fraud, the FDIC in December reached a $1.69 million settlement agreement with the bank’s former officers and directors. Nearly all of the money was paid by the bank’s officers & board of directors’ liability insurance carrier, said FDIC spokesman David Barr.
Barr said the FDIC settled with the directors so it wouldn’t have to file a lawsuit against them. Barr declined to say what issues would have been raised in the complaint. “The FDIC, whenever a bank fails, we look into why that institution failed,” he said. “That is normal operating procedure for us.”
The FDIC now has turned its attention to the bank’s former accounting firm, BKD LLP of Springfield, Missouri. The FDIC blamed BKD, which has a large office in Little Rock, for allowing Lewis’ fraud to go undetected long enough to cause the bank to fail, the FDIC said in a lawsuit filed in December in U.S. District Court in Little Rock. The FDIC is seeking $17.5 million in damages.
BKD denied that it did anything wrong in handling the bank’s books and blamed the bank’s officers, who were “responsible for establishing the internal controls to prevent, deter and detect fraud,” according to BKD’s motion to dismiss the case.
The filings in the lawsuit have opened a new window into the collapse of First Southern and reveal how Lewis handled questions related to his phony improvement district bond scheme that killed First Southern, where Lewis was the majority shareholder, and defrauded other Arkansas banks of millions of dollars.
Lewis was sentenced in December 2011 to 121 months in federal prison after pleading guilty to one count of bank fraud. He also was ordered to pay $39.5 million in restitution to nine banks in what is considered the largest fraud prosecuted in Arkansas.
As of last week, Lewis, 46, has paid $2.17 million in restitution, according to the U.S. District Court Clerk’s Office. The office said, however, that the source of the restitution money or which banks have been paid wasn’t public information.
Lewis is serving his sentence in federal prison in Memphis and is scheduled to be released on Jan. 24, 2021.
Meanwhile, the FDIC’s receiver is winding down its involvement with First Southern, said Barr, the FDIC spokesman.
As of June 30, the receiver had only $23,000 worth of the bank’s assets left to liquidate, according to the receivership balance sheet summary posted on the FDIC’s website.
The FDIC estimated at the end of 2013 that the loss associated with the failure of First Southern would be $27 million, Barr said. He said the loss would be absorbed by the FDIC’s insurance fund.
The FDIC’s loss might be reduced, though, if the receiver is successful in the lawsuit against BKD.
The FDIC asserts in its lawsuit that, had BKD had done its job, Lewis could have been exposed as a criminal in mid-2009, almost a year-and-a-half before he was. But it wasn’t until the fall of 2010 that FDIC examiners, during a routine examination, discovered that all 23 improvement district bonds that the bank had bought from Lewis since 2008 — $23.3 million worth — were fake. The bonds exceeded the bank’s equity capital of $19.3 million.
First Southern began operating in 2005, and on the last day of 2008 it bought its first bond peddled by Lewis: $750,000 from Hay Meadow Property Owner Improvement District No. 1. Bank officials wouldn’t learn until late in 2010 that the improvement district didn’t exist.
Before the scheme was uncovered, though, the bank recorded those bond investments as loans in its financial statements.
In April 2009, First Southern CEO Woody Castleberry asked BKD how it should handle bonds on its books.
“We would prefer to book them as bonds in our portfolio, but we thought we should get your input,” Castleberry said in an email to BKD that was attached as an exhibit in BKD’s filings.
Castleberry also touted how solid the bonds were.
“These are small, Arkansas improvement districts that have been formed with the assistance of the law firm of the fellow who is the driving force behind” buying the majority ownership interest in the bank, he wrote about Lewis. At that time, Lewis was buying a majority interest of the bank through a trust he created with his children as the beneficiaries.
“I’ve looked into them … and they are excellent investments, especially given the tax free yields they offer,” Castleberry said in the April 2009 email. “They pay annual equal payments of principal and interest.”
BKD’s managing partner, Ryan Underwood, then asked Castleberry if the bonds were private placement or if they had been available for sale to the general public. He also wanted to know what percentage of the bonds the bank bought.
Castleberry turned the questions over to Lewis, who began covering his tracks.
Lewis, in an email response, said the bonds were private placements. But the answer he gave Castleberry to Underwood’s other question was convoluted:
“Oftentimes, there are multiple bonds issued by the same issuer in the same series that are divided amongst buyers,” Lewis wrote in the April 7, 2009, email to Castleberry. “Other times, there can be multiple series from the same issuer but there might just be one bond in the same series, e.g., ABC issuer has 2002A, 2002B and each series might have been different – Series 2002A might have 4 – $500,000 bonds = $2 MM issue and Series 2002B might have 1 – $300,000 bond.
“I realize that can be very confusing,” Lewis wrote. “See if that answers his questions.”
Based on Lewis’ answer, BKD’s Underwood suggested the bonds should continue to be classified as loans “since they would probably not qualify as investment grade,” he said in the April 2009 email exchange.
In June 2009, BKD conducted a loan review for the bank. The bonds, classified as loans, hadn’t been subject to BKD’s loan review procedures, and BKD noted that the bond files it had seen “had nominal documentation,” according to the FDIC’s lawsuit.
And that should have raised red flags, the FDIC said.
“Considering that even a cursory review of the Bond files would have raised concerns about the sufficiency of the documentation, it appears the BKD auditors did not review the files at all, or lacked the proficiency and technical training to understand the implications of the documentation deficiencies,” the lawsuit said. “Had a proper review of the Bond files been conducted, BKD would have determined that the Bonds were fraudulent, which it would have been required to report to [First Southern Bank] management.”
Between December 2008 and Oct. 5, 2009, First Southern bought 13 bonds through Lewis for a total of $10.8 million. The bank bought 10 more bonds from Lewis for a total of $12.5 million between Dec. 16, 2009, and Sept. 29, 2010.
The FDIC is suing for professional negligence, gross negligence and breach of contract.
BKD Cites Limits of Control
BKD said in its motion to dismiss the FDIC’s complaint that First Southern Bank knew that the 2009 audit wasn’t designed to detect fraud.
“The FDIC has failed to plead what, where, when and how BKD would have discovered Lewis’ fraud against FSB that FSB itself never detected,” according to the motion filed by its attorneys, Philip Kaplan of Little Rock and Timothy McNamara of Kansas City, Missouri.
BKD said in the lawsuit that when it was hired in June 2009 to conduct the 2009 audit, it warned First Southern that the audit isn’t “designed to provide assurance on internal control. … Because of the limits of internal control, errors, fraud, illegal acts or instances of noncompliance may occur and not be detected.”
BKD also blames First Southern’s management for not doing a better job at detecting the fraud.
“The FDIC’s Complaint pleads a world where FSB bankers apparently had little or no responsibility for investigating the particulars of each proposed transaction, meeting the principals, inspecting construction plans or existing infrastructure, or otherwise exercising appropriate due diligence,” BKD said in its motion.
The FDIC’s Barr declined to comment on the lawsuit. BKD’s attorney Kaplan referred questions to McNamara, who didn’t immediately return a call last week.
What’s Necessary to Win
In order to win the lawsuit, the FDIC will have to show that BKD deviated from the general accepted auditing standards, said George Washington University law and accounting professor Lawrence Cunningham, who wrote the textbook “Introductory Accounting & Auditing for Lawyers.” It also will have to show that “if these steps had been taken properly, they’d have found out that these bonds were phony far earlier on, minimizing all those losses,” he said.
For BKD to prevail, it will have to show that it followed the accepted auditing standards and argue that “sometimes these crooks are so good that not even a great auditor can” detect the fraud,” Cunningham said.
BKD might be helped in making that argument by the fact that eight other banks either bought phony bonds from Lewis or loaned him money secured by the worthless bonds. Two other banks were stung by Lewis because they loaned him money to buy the controlling interest in First Southern and the shares of First Southern stock that he used as collateral were worthless when the bank failed.
U.S. District Court Judge James Moody Jr. hasn’t ruled on BKD’s motion to dismiss as of Thursday, but the case has a proposed trial date of July 13, 2015.