Opinion ID: 510320
Heading Depth: 2
Heading Rank: 1

Heading: 1968-1969--The Sale of Kennibec

Text: 3 In 1968, a group of health spa owners--all of whom were defendants at one time or another in the present case--decided to go public. 1 Rather than go through the process of preparing a registration statement for the Securities and Exchange Commission the spa owners decided to acquire a public corporation and transfer the assets of the spas to the public corporation in exchange for stock. Through this process, the non-public spas would be transformed into a public corporation. As a result, any subsequent public offering of stock would be greatly expedited by the fact that the business was already a public company. 4 The corporation chosen for this purpose was a shell corporation named Kennibec Mining Company. Based on a predetermined allocation, six million shares of Kennibec stock were distributed to the owners of the various health spas, and the assets of the spas were transferred to Kennibec. 5 When Kennibec's directors investigated the prospect of a public offering of Kennibec the result of their initial inquiries was not encouraging. Investment bankers that were approached indicated reluctance to underwrite a public offering of Kennibec. In particular, two objections appear to have been advanced. First, a general concern existed that a health spa organization would not be an attractive investment vehicle for public shareholders. Second, the accounting method that had been and was still being used by the various spas--specifically the fact that their books were kept on a cash basis rather than on an accrual basis--made it impossible to prepare a financial statement for submission to the SEC. 6 In an effort to resolve the second objection, Kennibec's directors began searching for an accounting firm to audit Kennibec. Joseph Bond, Kennibec's secretary-treasurer, contacted three accountants: Lorin Burr, an accountant with Ernst & Ernst; J. Robert Thomas, an accountant at Birrell, Zimmerman & Thomas; and Joseph Burns, an accountant with Touche. Eventually, Bond hired either Birrell, Zimmerman & Thomas or Touche to audit Kennibec. 2 Soon after, the firm of Birrell, Zimmerman & Thomas merged with Touche. 7 In a memorandum drafted on June 11, 1968, Joseph Burns, the Touche accountant, outlined his view of the appropriate accounting method for auditing Kennibec. In brief, Burns advocated a method under which an amount of income equivalent to the costs associated with acquiring memberships--advertising cost, commissions, and other incentive compensation costs--would be immediately recognized as income at the time the memberships were sold. All other income would be amortized on a decelerating basis over the life of the membership. 8 In July 1968, Touche attempted to audit Kennibec for a nine month period ending June 30, 1968. In October 1968, however, Touche refused to complete the audit and instead issued a Disclaimer of Opinion report. According to the report, Kennibec's use of the cash basis method of accounting for the health spas may [have] result[ed] in a significant overstatement of retained earnings. 262 R. 2403. As a result, Touche concluded, we have reason to believe that the combined balance sheet does not fairly present the company's financial position in conformity with generally accepted accounting principles. 262 R. 2403-04. 9 In late September or early October, 1968, Touche again undertook to audit Kennibec, this time for the fiscal year ending September 30, 1968. In that audit, completed in March 1969, Burns rejected the accounting method he had previously endorsed on the grounds that it was exceptionally conservative, and failed to reflect the economic facts of the company's operations. 263 R. 2825. Instead, Burns utilized an approach known as the front-end method. Under it all revenue [was] recognized at the time of sale [of the membership contracts] except that an amount equivalent to the total cost of providing member services over the life of the contract [was] deferred. 263 R. 2827. The amount deferred--somewhere between twelve and fifteen percent of the income--was then amortized on a straight line basis. 10 In the spring of 1969, in preparation for an S-1 Registration Statement to be filed with the SEC, Touche performed a subperiod audit of Kennibec covering the period from September 30, 1968 to April 30, 1969. Before any registration statement was filed, however, the directors of Kennibec began discussing the possibility of merging with another company rather than going public. 11 One of the companies that had indicated an interest in acquiring Kennibec was USI. On October 20, 1969, USI and Kennibec entered into an Exchange Agreement under which USI would acquire eighty percent of Kennibec's stock in exchange for shares of USI preferred and common stock. The Exchange Agreement provided that Kennibec's executive officers--Rice, Melby and Bond--would remain as the president, vice-president and secretary-treasurer of Kennibec respectively. It also contained a number of warranties and representations including (1) that the financial condition of Kennibec was accurately reported in the company's financial statements according to generally accepted accounting principles consistently applied; (2) that Kennibec had good title and the right to use or lease Kennibec properties as set out in the schedules attached to the Exchange Agreement; (3) that all conflicts of interest, related-party transactions and acts of self-dealing had been fully and fairly disclosed; and (4) that the proceeds from the four million dollar loan from USI to Kennibec would not be used by any of the selling shareholders to satisfy personal obligations. 3 Finally, the sale was expressly conditioned on an unqualified favorable opinion by Touche on the financial condition of Kennibec. 12 On December 2, 1969, the Exchange Agreement between Kennibec and USI was closed and shortly thereafter Kennibec was renamed Health Industries, Inc. (HI).