July/August 2008

Fraud and the Crooked Majority Shareholder

In a reversal of roles that often lead to fraud, it was the absentee owner who was picking the pockets of his on-site management team

Andrew D. Pappas, CPA

While the following account is based on an actual case, the facts have been simplified and the names of all parties have been changed.

Savage Crushing is a $10 million East Valley crushed stone company that produces and delivers concrete aggregate, sand, gravel and decorative rock. Founded in the 1950s by a local sand and gravel operator, the company was purchased in 1998 by Bick Savage, a California man who owned a half-dozen mining operations in the western U.S.

As an absentee owner, Bick knew the importance of assembling a talented management team to run the business’s day-to-day operations. He attracted top-level managers to head his production, transportation, sales and administrative divisions. Under Bick’s guidance the managers led Savage Crushing to impressive growth in sales and profitability for several years in a row.

Part of Bick’s success in attracting and retaining good managers was his willingness to give them stock, pursuant to their employment agreements, in addition to their salaries. By 2002 each of his managers owned 10% of the stock in Savage Crushing, a subchapter S corporation.

Bick’s sharing of the company’s financial information consisted of Schedule K-1, which showed each owner’s share of the company’s taxable income. In the early going, the managers didn’t question the accuracy of their K-1s; business was good, and their distributions were a welcome addition to their pay. But by 2006, it appeared to Jerry, the transportation manager, that his distribution wasn’t keeping pace with the obvious increases in the company’s production and deliveries. He discussed the issue with his fellow managers and, with their concurrence, he raised it with Bick during a November 2006 management meeting.

In response to Jerry’s request for copies of Savage Crushing’s financial statements, Bick said that their request was reasonable and apologized for not automatically providing them. Savage Crushing’s fiscal year end was December 31. He said that the company’s CPA firm would be putting together the 2006 financials in early 2007 and that he would give copies to all of the manager-shareholders as soon as he received them.

In late March 2007, the managers received their K-1s in a timely fashion but without the promised financial statements. When they asked Bick about it, he said that his bank had required him to provide audited statements and that it would probably be May or June before he would have the finished product. Jerry replied that he would be happy with an unaudited version of the financials, just to satisfy his curiosity. Bick seemed reluctant to comply, and Jerry, not wanting to get on the boss’s bad side, let it go.

In late June, with still no financial statements in hand, Jerry asked the administrative manager, Dave, to call Bick’s California accounting firm to check on the status of the audit. The managers were dismayed to learn that the audit was finished and the financial statements had been delivered to Bick more than six weeks earlier. In a phone call to Bick later that day, Jerry asked him about the status of the financial statements. Again Bick apologized, adding that he was at his gypsum mine in Utah and that he would overnight the statements to his managers as soon as he returned to his California office.

Trouble. When a week passed without receiving the statements from Bick, his Arizona management team met to discuss what to do about the situation and their growing suspicions about their boss. At that meeting, they decided that Jerry would hire an attorney to demand that Bick provide him with the requested financial information. Upon receiving the request from Jerry’s attorney, Bick fired all four minority stockholders. He then offered to buy back their stock for $60,000 each, a price that they estimated to be about 30 cents on the dollar.

Each of the terminated minority shareholders hired his own attorney to pursue a wrongful termination action against Bick and to force him to disclose Savage Crushing’s current financial condition as the basis for a more favorable buyout of their minority interests.

In the ensuing legal battle, the minority shareholders were at a distinct disadvantage. They had to pay the fees of their attorneys and forensic accountants out of their own pockets, while Savage Crushing paid for Bick’s legal and other professional fees.

In addition, Bick directed Savage Crushing to issue the minority shareholders’ K-1s but to withhold payment of any distributions. Stuck with a tax bill but without the cash to pay it, each of the minority shareholders had to pay the taxes on their “phantom income.”

Investigation

Amid this legal and financial turmoil, the attorneys for the four minority shareholders hired Pappas & Company to perform a financial investigation of Savage Crushing. We were jointly engaged so that the cost of our services could be spread among the plaintiffs.

Fortunately for our clients, Bick’s accounting firm had indeed audited Savage Crushing’s financial statements in the spring of 2007, and our review of that audit and the supporting documentation revealed why Bick had failed to share the company’s financial information with his manager/shareholders. Among our findings were these:

We determined that Bick’s offer to purchase the minority stock was based on a multiple of five times average reported pre-tax earnings per share for 2005 and 2006. In accordance with direction from Jerry’s attorney, we did not challenge this multiple but instead adjusted earnings per share to reflect arm’s length amounts for each of the inappropriate transactions described above. Also, we determined fair market rental and interest rates for the fixed asset rentals and intercompany loans and performed a “reasonable compensation” study to determine appropriate bonus amounts for Bick, based on the services he actually provided to Savage Crushing.

Based on our analysis, we determined that the buyout price at a multiple of five times pre-tax earnings should be $300,000 per shareholder, rather than the $60,000 offered by Bick. In addition, each of the minority shareholders should have received additional distributions of $100,000 for 2005 and again for 2006 as their share of the portion of Bick’s bonuses that were actually disguised dividends, since the bonuses were in excess of reasonable compensation for the services provided by Bick.

Settlement. After much negotiation and a mediation hearing, the parties settled on a $360,000 payout for each shareholder. Although the settlement provided $140,000 less per shareholder than our findings suggested was appropriate, the shareholders still received six times the amount offered by Bick.

The Moral of the Story

The hard lesson for the four manager/shareholders was that, in a closely held company, the power lies with the majority owner.

In order to level the playing field, Jerry and the other managers should have insisted on a shareholder agreement that provided for the sharing of financial information and for stock redemption terms and conditions, including events that trigger the redemption, a method to determine the redemption price, and the terms for payment of that price. If such an agreement had been in place, Jerry and his allies might still be running Savage Crushing, earning good salaries and continuing to build their wealth though the increase in the value of their stock.

While the preceding account is based on an actual case, the facts
have been simplified and the names of all parties have been changed.

Pappas & Company, Ltd. • 7373 E. Doubletree Ranch Rd., Suite 180 • Scottsdale, AZ 85258-2036 • 480-596-8333