THE KENYON HOME FURNISHINGS CASE

By Donald F. Clarke

The call to my firm by Bank of New York Commercial Credit (BNYCC) in April 1989 to perform  a $60 million new business survey on Kenyon Home Furnishings located in High Point, North Carolina was fairly routine.  The subsequent discoveries and disclosures however were far from routine.

As is typical in surveys of this magnitude, we received short notice and were advised that there were two or three other lenders eager and ready to do the deal.  I dispatched Frank Tranes (now deceased) the next day, Wednesday to start the audit.  On Friday, I received a call from the lender at BNYCC stating that the other lenders were all ready to issue commitments and we needed to expedite the process.  On Monday the following week, I joined Frank to assist him in the process.  By the time I got to High Point, Frank had already completed the receivable review so I decided to delve into the cash section of the audit.  Cognizant of the fact that another lender was already in the picture, I was attempting to determine if any cash diversions were evident.  I began my examination of cash by requesting cancelled checks for the six months ended March 1989.

1.         Company Background

Kenyon was a manufacturer of leather home furnishings namely chairs, loveseats and sofas.  It imported leather from Brazil, Argentina and Italy and did its manufacturing at its captioned address.  The company had grown rapidly, with sales peaking at in excess of $124 million (annualized) at the time of the survey.  Kenyon first borrowed under an asset based lending formula from State Street Bank and Trust and switched to Bankers Trust three years prior to our visit.  During the three years at Bankers Trust, it was reported that Kenyon received three line increases, peaking at $35 million at the time of our visit.  The request to BNYCC was to almost double its line to $60 million.

2.         Cash Audit Discoveries

(a).       Cancelled Checks

 Kenyon’s accounts payable were completely automated with the computer cutting checks based on vendors’ due dates.  The checks cut by the computer were tan in color with each monthly stack averaging about six inches tall.  As I flipped the cancelled checks to examine fronts and backs, the month of March 1989 caught my attention.

There was a thin blue border nestled in the stack of checks for March.  Neatly tucked in the March cancelled checks (tan in color) were twenty nine blue “manual” (handwritten) checks all written between March 1st and 3rd 1989, payable to three main suppliers as follows:

 9 checks totalling $278,600 payable to “Moda” (Italy)

 11 checks totalling $518,300 payable to “Indiscuer” (Argentina)

 9 checks totalling $405,800 payable to “Pinheiros” (Brazil)

In total, these checks amounted to $1,202,700.  Upon examining the backs of the checks it was noted that all twenty nine checks were hand endorsed as follows:

Moda   -           endorsed by     Roger Cates

Indiscuer -        endorsed by     Kurt Freeman

Pinheiros -        endorsed by     Bryan Jerome

The first observance is that none of these endorsing signatures appeared foreign, in sync with the countries these vendors were domiciled in.  Secondly, there were no depository account numbers on the backs of the checks, indicating that the checks were cashed rather than deposited.  Thirdly, all twenty nine checks were negotiated at Wachovia Bank in Thomasville, North Carolina approximately ten miles away.  One would assume that if these corporate checks were to be cashed by individuals then it would have been “easier” to do so at American Bank and Trust in Kenyon, North Carolina on which the checks were drawn.  Fourthly, upon further examination it appeared that the preparer of the checks (Kenneth Kockekian, President of Kenyon) and the endorsers Messrs Cates, Freeman and Jerome shared the same hand writing styles (see exhibits included). 

Checks in hand, I walked into Mr. James Pearce’s (Chief Financial Officer) office seeking an explanation.  Mr. Pearce advised me that the vendors’ representatives were in town at a trade show and wanted payments on outstanding invoices.  Nagging questions however remained and so I elected to go through my secretary Gigi Cruz, to find someone who spoke Portuguese and Italian.  Having found such persons, I had them call Moda in Italy and Pinheiros in Brazil to inquire if either company had knowledge of the endorsers of these checks.  Neither company knew of Roger Cates or Bryan Jerome.

(b).       Review of Bank Deposits

 

A routine part of a new business survey is to review a company’s source of funds, particularly if there is a lender of record, to determine if any cash diversions exist.  I requested Kenyon’s operating bank account statements and proceeded to check to see what other deposits were made besides the Bankers Trust advances.

I made the following discoveries:

In the months of February and March, 1989 Kenyon sold inventories for cash, the proceeds of which were deposited into their operating account at American Bank and Trust, rather than remitted to Bankers Trust which had a loan on the inventory.  These deposits were as follows:

2/2/89                          $402,000

Late Feb. 1989             $972,700

3/8/89                           $529,300

It was remarkably coincidental that such deposits (“diversions”) occurred with such close proximity to the irregular checks noted earlier. 

When confronted about this irregularity, Mr.  Pearce explained that it was a “mistake” and that Bankers Trust was aware of this.  He also stated that BNYCC had been made aware of this “error” and had no problems with it.  BNYCC was not aware that this had happened!

3.         Accounts Receivable

 The review of receivables by Frank Tranes yielded mixed results.

-           Dilution of sales was 4% supporting the proposed 85% receivable advance.

-           Receivable turnover of 114 days was alarming, although the customer base consisted of major national chains such as Macys, Mays, Hechts, G. Fox, Marshalls, Robinsons, Rhoades, among others.  Historically, such chains pay slower and take the discounts anyway.

-           Aging spread condition reflected 18.4% over 90 days versus 27% the prior year which had shown turnover of 126 days.

The clincher came however when, uneasy about everything I saw in my two days at this company, I informed Mr. Pearce that I was going to do telephone verifications of receivables.  Mr. Pearce objected strongly to this, citing that customers might be unduly alarmed.  He suggested that more benefit would be gained by reviewing Ernst Whinney’s year end 12/31/88 confirmations (Ernst and Whinney had issued certified, unqualified opinion on Kenyon at fiscal year end 12/31/88.)   Ernst and Whinney verified 76% of outstanding receivables through the mail!

What’s wrong with this?  Everything.

Considering that the customer base is comprised of major chains, receiving a 76% verification is almost impossible.  I was looking for something in the range of 40%.

The FBI agent in charge later told me that Kenyon had opened post office boxes in the major cities where its customers were domiciled.  The accountant sending out the confirmation did not feel that it was unusual for all the major customers to have post office boxes for their accounts payable departments.  When confirmations were mailed, Kenyon would dispatch employees to recover them!

4.         Inventory Discoveries

In reviewing Frank’s work on the inventory, something very troubling surfaced.  The company reported total inventories of $13,179,900 at 3/31/89, however, 41% was in transit which is a high amount for a company doing manufacturing and needing raw materials on a timely basis.  In addition, the company carried only $600,000 in insurance coverage on these inventories.

Kenyon’s reported sales from financials showed a sales growth of 141% over the prior year ($125 million vs $52 million) making one wonder how the present inventory levels could service such growth.  In addition, the company purchased over 60% of its inventory for “cash”, which created questions as to where this “cash” came from, given the slow turn on receivables.

The FBI investigation revealed that the “in-transit” inventory levels were nowhere near what they were reported to be.

5.         Audit Conclusions

Armed with the foregoing discoveries the audit suggested a decline of the loan proposal, based  on the following:

BNYCC declined the facility and informed Kenyon’s parent Federal Resources Corporation of the findings.  Federal, armed with this information sent an internal audit team down to pursue the audit discoveries.

On May 31, 1989, Federal’s stock was removed from active trading on the stock market and Messrs. Kochekian and Pearce were removed from Kenyon’s premises (see Wall Street Journal article exhibit dated 5/31/89).

Shortly after, Kenyon filed Chapter 7 bankruptcy after FBI intervention and Bankers Trust reportedly sustained loan losses in excess of $30 million, after the dust had settled. 

Messrs. Pearce and Kocheckian were handed down relatively stiff prison sentences, and several lawsuits ensued and are continuing until this day.

The lessons to be learned here are compelling.  The most important being that the audit staff of the asset based lender must be diligent in its pursuit of the truth by not just being “number takers”, because the nature of this type of lending makes it inherently vulnerable to fraud.

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