Case study is attached and the Instructions are attached as well
INTRODUCTION After graduating from West Virginia University in 1984 with a degree in accounting and finance, Gregory Podlucky decided to work with his father Gabriel, who had a small business empire in western Pennsylvania that included a chain of auto parts stores, an ethanol fuel company, several real estate properties, and the Jones Brewing Company, best known for its line of Stoney’s beers. In 1989 Gregory Podlucky decided to strike out on his own. Using the funds he obtained from cashing out his ownership interest in his father’s businesses, Podlucky established a water bottling venture in Latrobe, Pa., the hometown of golfing great Arnold Palmer. In 1992, entrepreneur and former CPA Podlucky expanded his product line to include a wide range of flavored water, fruit, and tea drinks. Despite being in the hypercompetitive beverage industry, Podlucky’s company, which he ultimately named Le-Nature’s Inc., grew rapidly. By 2006, the company was the 33rd largest beverage producer in the United States, with annual reported sales approaching $290 million and a workforce of several hundred employees. One year earlier, Podlucky had rejected a $1.2 billion offer to sell Le-Nature’s. Instead of selling, Podlucky decided to take his company public. Unfortunately for him, his fellow investors, and his company’s many creditors, that dream was never realized. STRATEGIC FINANCING Podlucky served as Le-Nature’s chief executive officer (CEO) and relied principally on his family and wide circle of friends and business associates to staff the company’s other key positions as it expanded over the years. He hired his brother Jonathan to serve as Le-Nature’s chief operating officer (COO) and placed his 22-year-old son Jesse in charge of the day-to-day accounting for Le-Nature’s large subsidiary that produced bottled tea products. Among the friends that he appointed to management positions at Le-Nature’s was Robert Lynn, who held different titles during his years with the company, including executive vice president of sales. Despite serving as Le-Nature’s CEO, Gregory Podlucky was also heavily involved in the company’s routine accounting functions.1 Tammy Andreycak, another close friend of Podlucky, held the title of director of accounting, and was the organization’s chief accountant. But Andreycak was a single mother who did not have a college degree or formal training in accounting. According to company insiders, her primary role within Le-Nature’s was serving as Podlucky’s confidante. When dealing with third parties, Podlucky often referred to Andreycak as his secretary.2 A shortage of capital is a common problem for rapidly growing small companies. Therefore, Podlucky relied on a variety of different strategies to finance his company’s expanding operations. During the 14 years that he served as Le-Nature’s CEO, the articulate and outgoing Podlucky raised almost $1 billion of debt and equity capital for the company. IMA EDUCATIONAL CASE JOURNAL VOL. 8 , NO. 4 , ART. 1 , DECEMBER 20151 ISSN 1940-204X Le-Nature’s Inc. Fraud: What Happened and Why? Michael C. Knapp McLaughlin Chair in Business Ethics and Professor of Accounting University of Oklahoma Carol A. Knapp Assistant Professor University of Oklahoma ©2015 IMA In 1999, Podlucky retained a financial consulting firm to identify potential investors for Le-Nature’s. In 2000 and 2002, that consulting firm arranged for two investment funds to collectively purchase eight million shares of Le-Nature’s preferred stock, which they had the right to convert into the company’s common stock. If the two funds had exercised the convertibility option, they would have controlled 45% of Le-Nature’s outstanding common stock. Instead, Podlucky owned all of his company’s outstanding common stock throughout its existence. The sales of preferred stock raised nearly $30 million for Le-Nature’s. Those transactions directly affected Le- Nature’s corporate governance structure because each of the investment funds that purchased the preferred stock had the right to appoint an individual to the company’s board of directors. The majority of the board consisted of “inside” directors including Podlucky, his brother Jonathan, and other senior company executives. Podlucky also used long-term equipment leasing as a financing technique. In one such transaction, Podlucky retained a North Carolina leasing agent to contract with a Wisconsin-based company that was a subsidiary of a German manufacturing firm. The German firm manufactured equipment Le-Nature’s used in its bottling operations. With the North Carolina leasing agent serving as an intermediary, Le- Nature’s leased the equipment from the Wisconsin subsidiary of the German firm. The leasing agreement required Le- Nature’s to make a large escrow deposit with the leasing agent; Le-Nature’s borrowed the funds to make that deposit from a U.S. lender. In total, Podlucky financed the acquisition of approximately $300 million of equipment in this manner. Podlucky used conventional long-term borrowing arrangements as the primary method for raising funds for his company. Wachovia, a diversified financial services firm based in North Carolina, arranged or underwrote approximately $500 million of long-term debt for Le- Nature’s.3 In 2005, for example, Wachovia marketed a $150 million bond issue for the company. The high-yield or “junk” bonds were sold primarily to pension and retirement funds such as CalPERS (California Public Employees Retirement System), the nation’s largest pension fund. Podlucky relied heavily on Le-Nature’s audited financial statements to borrow funds for his company. For example, in the case of the $150 million bond issue, Wachovia included Le-Nature’s audited financial statements with the promotional materials for those bonds. Likewise, Moody’s Investors Services accessed and relied on Le-Nature’s financial statements to assign credit ratings to those bonds— and the company’s other outstanding debt obligations. SUSPICIONS AND RESIGNATIONS SPARK INVESTIGATION In August 2003 Le-Nature’s independent audit firm, Ernst & Young (EY) was completing its review of the company’s financial statements for the second quarter of fiscal 2003. During the EY quarterly review, a standard procedure was to ask a client’s senior executives whether they suspected or were aware of any fraudulent activity within the organization. When Richard Lipovich, the EY audit engagement partner, posed that question to John Higbee, Le-Nature’s CFO at the time, Higbee candidly replied that he had significant doubts about the reliability of his company’s recorded sales figures. Lipovich received similar responses from Le-Nature’s chief administrative officer (CAO) and its vice president of administration (VPA). The day after communicating their concerns to Lipovich, the three company officials submitted letters of resignation to Gregory Podlucky. In their resignation letters, the three former executives suggested that Podlucky was “engaging in improper conduct with Le-Nature’s tea suppliers, equipment vendors, and certain customers.”4 Higbee—who had served for 20 years as an audit partner with Arthur Andersen & Co., including 16 years heading up the audit practice for that firm’s Pittsburgh office—reported that Podlucky had repeatedly refused to provide him with documentation supporting key transactions reflected in Le-Nature’s accounting records. He considered Podlucky’s failure to provide such documentation “an astonishing and extremely improper restriction for any executive officer to impose upon a company’s chief financial officer.”5 Those restrictions made it impossible for Higbee to satisfy his CFO-related corporate governance responsibilities. Higbee also identified what he considered to be several material weaknesses in Le-Nature’s internal controls. Those weaknesses included Podlucky’s “absolute control” over the company’s “detailed financial records” and the lack of “checks and balances” for key assets of the company, such as the large escrow deposits for its long-term equipment leases and its product inventories.6 The startling statements by Higbee and his two former colleagues in their resignation letters prompted Lipovich to write a letter to Le-Nature’s board of directors. In that letter, Lipovich requested that Le-Nature’s retain an independent law firm to investigate and file a report regarding the allegations made by the three former company executives. Lipovich informed Le-Nature’s board that EY would not be associated with any of the company’s financial statements until the law firm completed its investigation, EY reviewed IMA EDUCATIONAL CASE JOURNAL VOL. 8 , NO. 4 , ART. 1 , DECEMBER 20152 the report, and EY determined if it had to undertake any other investigative procedures. Le-Nature’s board responded to Lipovich’s letter by creating a Special Committee to investigate the allegations made by the three former executives. That committee was made up of the outside members of the company’s board, which included the directors appointed by the investment funds that had purchased Le-Nature’s preferred stock. The Special Committee retained an independent law firm, K & L Gates (one of the 10 largest legal firms in the United States) to supervise that investigation. In turn, K & L Gates hired an independent accounting firm, Pascarella & Wiker, to assist in the investigation. In late November 2003, K & L Gates submitted a draft copy of its report to Podlucky, who was not a member of the Special Committee. The CEO provided feedback regarding the report to the law firm. One week later, K & L Gates provided a revised copy of the report to the members of the Special Committee. The report “found no evidence of fraud or malfeasance,”7 although it did identify multiple internal control weaknesses. Among the suggestions made to remedy those internal control weaknesses were strengthening the segregation of duties for key transactions such as equipment leases and inventory purchases, adopting more rigorous documentation standards for those transactions, and establishing an audit committee consisting of outside directors. The outside directors on the Special Committee accepted the findings of the investigative report and indicated that they would work with the other members of Le-Nature’s board of directors to address the identified internal control problems. Shortly thereafter, Le-Nature’s dismissed EY as its independent audit firm and retained BDO Seidman, which would ultimately audit the company’s 2003 through 2005 financial statements. FRAUD ALLEGATIONS RESURFACE Following the 2003 investigation, Gregory Podlucky rededicated himself to enhancing his company’s stature and size in the beverage industry. Le-Nature’s impressive financial data caught the attention of several private equity funds in 2005 when Wachovia prepared and distributed a confidential memorandum to sell the company to the highest bidder. The initial bid received for the company was $1.2 billion. To the disappointment of the company’s preferred stockholders, Podlucky rejected that offer. The preferred stockholders claimed that Podlucky intentionally sabotaged the sale of Le-Nature’s by refusing to allow the potential buyer access to the company’s accounting records. Podlucky dismissed that allegation and instead maintained that he had rejected the buyout offer because the price had been too low. In May 2006, the preferred stockholders filed a lawsuit against Le-Nature’s, Podlucky, and other top executives to force an outright sale of the company. Despite that lawsuit, Podlucky began preparing an initial public offering (IPO) for Le-Nature’s with the assistance of K & L Gates. At the same time, Wachovia was in the process of arranging more than $300 million of additional long-term loans for Le-Nature’s. Podlucky’s plans for his company were disrupted when allegations of an accounting fraud within Le-Nature’s resurfaced. The CEO responded to those allegations by pointing to the fact that his company’s financial statements had received an unqualified audit opinion each year from Le- Nature’s independent auditors. Podlucky also insisted that “the financial stability of Le-Nature’s has never been stronger”8 and boldly predicted that Le-Nature’s sales would nearly quadruple over the next four years from approximately $290 million to more than $1 billion annually. In October 2006, Le-Nature’s preferred stockholders requested a restraining order against the company in a petition they filed with a Delaware court. In the petition, the preferred stockholders referred the court to a fraudulent equipment leasing transaction arranged by Le-Nature’s. One of the lenders that provided the financing for the company’s long-term leases had determined, with the assistance of a handwriting expert, that certain documents for the given transaction had been forged. The forged documents had resulted in $20 million of the lease escrow deposit financed by the lender being improperly transferred to Le-Nature’s. The Delaware court issued the requested restraining order, evicted Podlucky from the company’s corporate headquarters, and appointed Steven Panagos of Kroll Zolfo Cooper (a consulting firm specializing in corporate turnarounds and restructuring) to serve as the custodian of Le-Nature’s assets and operations. Less than one week later, Panagos filed an affidavit with the court that presented evidence of a massive accounting fraud within the company. He also reported that he had found evidence that Podlucky had “frantically shredded company documents”9 before he was forced to leave Le- Nature’s corporate headquarters. Even more troubling was the custodian’s discovery that the company had been maintaining