Opinion ID: 353796
Heading Depth: 1
Heading Rank: 2

Heading: the scheme as assembled: staying public.

Text: 23 HKF Audits the 1969-1970 Fiscal Year. 24 During August and September, 1970, HKF again met with Homex, this time to certify the financial records of Homex for the 1969-1970 fiscal year. In connection with this audit, Paul Kuveke, then Executive Vice-President and Treasurer of Homex, wrote a letter to HKF stating that, although both the Kece and Reseac mortgages were in default in the amount of $559,624 as of the end of the fiscal year, Homex nevertheless considered them collectible and properly recognizable as income for auditing purposes. He cited as reasons for this belief the receipt from Kece on September 27, 1970, of a payment that brought its obligations up to date; the expectation that a Reseac payment would also be received, given what appeared to be favorable business conditions for Reseac; and a recent appraisal of the parcels that placed the fair market value of the Kece land at $310,000 and the Reseac land at $403,650. The Kece Mortgage Payment 25 The Kuveke letter failed to disclose to HKF the rather complicated set of transactions that facilitated the September 27, 1970, Kece mortgage payment. Thun and the Stirlings were involved in a number of enterprises besides Hollyrood Park Associates. Among these were Fairway Associates, the owner of an apartment development in Rochester, New York; Mobile Townes Corporation, the owner of a mobile home park in Syracuse, New York; and Pennscott Properties, a management company for Mobile Townes. 26 In September, 1970, a dispute arose regarding claims by Homex that Thun and his various enterprises owed approximately $90,000 to Homex and its subsidiaries. From the record, it appears that this $90,000 consisted of approximately $34,000 due Homex for the construction of a clubhouse on Hollyrood Park property, approximately $35,000 on a demand note held by Homex and, apparently, approximately $23,000 due on September 2, 1970, as mortgage payment on the Kece-Riverbend parcel. It was Thun's opinion that the best way to clear up the confusion was for his enterprises to buy out the Stirlings' interests in Mobile Townes and Pennscott, thereby simplifying the ownership of the various corporations and at the same time providing payment to the Stirlings. 27 Jack Doerge, a director of Mobile Townes, indicated to Thun that he was interested in acquiring additional Mobile Townes stock and would transfer $90,000 for that purpose. $90,000 was delivered to Al Bartz of Homex in exchange for Pennscott and Mobile Townes shares held by the Stirlings. The Mobile Townes stock was not, however, delivered that day. Instead, it was placed in escrow until Thun confirmed to HKF the authenticity of the purchase-money mortgage on the Kece-Riverbend property. On October 5, 1970, Thun confirmed to HKF that the mortgage was authentic. In effect, then, the same $90,000 that was used to purchase the Stirlings' stock in Pennscott and Mobile Townes was used to satisfy the disputed $90,000 indebtedness. At the same time, and in the same transaction, ownership of valuable stock was transferred, $90,000 worth of debts was forgiven, and Homex could present to its auditors a confirmed and therefore arguably collectible mortgage to support its recognition as income. 8 Reseac Developments 28 The Kuveke letter to HKF also failed to reveal significant background information regarding the Reseac land transaction. On July 16, 1970, Gerald Beckerman, the attorney for Falcone, Barbato and Shapiro, met with Carl Wren, Homex's Director of Market Research, and Ruben Davis, assistant to Yanowitch, in an effort to resolve problems that had developed regarding the property sold to Reseac. The problems were considerable: contrary to Homex's assurances, the zoning restriction had not been lifted; Falcone, Barbato and Shapiro had become quite disillusioned with the property and were no longer inclined to develop or retain it; Reseac had no cash and could not make the interest payment due on July 1, 1970; and, finally, Reseac could not pay the real estate taxes or the obligations on the assumed mortgages. In short, Falcone, Barbato and Shapiro wanted Homex to make good on its promises either to repurchase the land or arrange for another purchaser. 29 Wren and Davis made it clear to Beckerman that, although the land was considered to be a good financial value, Homex would not repurchase it. They did, however, offer to assist in the sale or development of the property. Beckerman indicated that Falcone, Barbato and Shapiro would be willing to continue in the arrangement as long as there was a waiver by Homex of the mortgage payments, a condition that Homex found unacceptable. The meeting was amicable, but it clearly met neither the hopes nor the expectations of the Reseac Principals. Kuveke's letter mentioned none of this. 9 Accounting Practices 30 The HKF audit of Homex's 1969-1970 financial condition prompted Homex again to shade the truth, this time in connection with the accounting methods utilized by the corporation. Typically, a Homex contract would state one price for the design and manufacture of modules and another price for their installation. At one time, Homex used sales contracts that transferred title and risk of loss to the buyer upon delivery of the finished apartment module to an independent carrier. When this contract was used, Homex recorded income from the sale of the module as of the moment the module was delivered to the carrier. During the 1969-1970 fiscal year, however, Homex changed to a turn key contract under which Homex retained title and risk of loss until installation was complete and a closing had occurred. Thus, the sale was not complete until after the closing, when the new owner could actually claim possession and turn the key. For obvious reasons, waiting to recognize income until the day that the key was turned troubled Homex officials. Homex, through Schulz, wanted HKF to certify as income the value of sales contracts for modules that, although not yet delivered or installed, had been manufactured and assigned to specific contracts. This method of calculation allowed Homex to recognize the manufacture price of a module as income long before it actually received any cash for that module. 31 During the 1969-1970 fiscal year, Homex also changed the provisions of its contracts dealing with installation. Where once Homex had not recorded any portion of the installation price as income until the installation was complete, Homex now wanted HKF to recognize as income that proportion of the installation price equal to the proportion of the installation completed. This system of recognition is called the percentage of completion method. 32 To support these methods of recognizing income, Schulz contacted and eventually retained Dr. Joseph A. Mauriello, an accounting professor at the New York University Graduate School of Business Administration. As a result of the conversations with Schulz, Dr. Mauriello submitted to HKF an opinion supporting Homex's income recognition system, and HKF approved of its use. What Schulz did not reveal to Dr. Mauriello, or to HKF, however, was the so-called Christman Incident. Earlier in 1970, David Christman, an assistant controller in Homex's installation division, had discovered that profits for the installation phase of Homex operations were going to be one-half million dollars less than what they had been projected to be. Schulz instructed Christman to delay recordation of the accounting entry embodying that calculation until after the close of the fiscal year. This delay prevented the reduction of the installment division's 1969-1970 profits by 60 percent and the reduction of Homex profits for that period by 11 percent. According to Dr. Mauriello, had the delay been disclosed to him, it would have altered his opinion regarding the propriety of the income reporting methods of the installation division. 33 The Route 57-31 Land Sale. 34 In December, 1970, Harold L. Wynn, Jr., and William Grago, Jr., partners in the Empire Pipeline Corporation, and their attorney, Carmen Grasso, met with David Stirling to discuss the purchase of 138 acres of land at the intersection of routes 57 and 31 in Clay, New York. The land was owned by Homex's land-holding subsidiary, Kabeth Properties, Inc. The purchase price of the land was.$2.1 million. A 30-acre portion of the land was then the subject of a state condemnation proceeding, for which an award of $1 million was anticipated. 35 Wynn told Stirling that, although the purchase price seemed fair, the three of them could not afford to make the investment. Stirling suggested that the condemnation award could go toward the purchase price and that he would accept a 10 percent down payment of $210,000 and a purchase-money mortgage with no principal or interest due for five years. Wynn responded that they could not even afford the down payment. Stirling then proposed that Homex arrange financing in such a way as to enable them to purchase the land without transferring any money whatsoever to Homex, and went so far as to assure sufficient business activity to enable payment of obligations that did arise. Although Stirling declined to give a requested corporate guarantee against any investment losses, he did give his personal guarantee to that effect. The parties agreed. 36 In order to facilitate the sale without the transfer of funds, Stirling and Yanowitch instructed Charles Marshall, former banker and then Homex employee, to arrange a bank loan to Route 57-31 Development Corporation (Route 57-31), a shell corporation set up by Wynn and Grago to take title to the property. He was instructed to negotiate the loan with First National Bank of Rochester, New York, and to assign the condemnation award due Homex as collateral. First National then loaned $250,000 to Route 57-31, requiring the personal guarantees of Wynn and Grago on the note. This was in turn paid over to Kabeth Properties. No closing occurred and no deed was transferred. 37 On January 6, 1971, Yanowitch, Schulz and Ruben Davis, then Assistant Vice-President and Associate General Counsel of Homex, met with Dr. Mauriello to discuss recognizing as income the.$1.4 million profit on the sale of land to Route 57-31 for.$2.1 million. The purpose of the meeting was to secure Dr. Mauriello's favorable opinion for use during the audit of the 1970-1971 fiscal year. In particular they discussed SEC Accounting Series Release No. 95, which commented on the propriety of real estate transaction accounting methods that recognized as income any profits not received at the time the transaction was recorded. 10 Dr. Mauriello eventually advised HKF that the sale of land by Homex to Route 57-31 was a bona fide sale for which income could and should be recognized as of the date of the sale. Neither the true scope of the agreement between Homex and Route 57-31 nor the nature of the background financial arrangements supporting the agreement was disclosed to Dr. Mauriello. Nor were the Homex auditors, HKF and its eventual successor, Peat, Marwick, Mitchell & Co. (Peat Marwick), told of those details. 38 In fact, David Stirling, Yanowitch and Schulz tailored the Route 57-31 sales contract so as to avoid possible auditor objections, and ultimately represented that there were no undisclosed assets pledged or assigned as security for liabilities and (t)hat the officers and directors of (Homex) had no direct or indirect relationship with Route 57 and 61 (sic) Development Corporation. 39 The Greater Gulf Coast Housing Development Corporation. 40 In late 1970, appellant Rubel Phillips, a Mississippi attorney, helped organize on Homex's behalf a group of Mississippi citizens into a non-profit public benefit corporation that would be eligible for federal, state and local financing of housing projects. The corporation was called the Greater Gulf Coast Housing Development Corporation (Greater Gulf). In December, 1970, Greater Gulf and Homex entered into two agreements. The first, for $100 million, called for the construction of a 5,000-unit housing project over a 6-year period, and was conditioned upon the modules being constructed in a Mississippi factory. The second, for $15 million, called for the construction of an 800-unit modular housing project over an 18-month period. These agreements, however, were effectively worthless unless and until Greater Gulf was successful in obtaining a funding commitment from appropriate government agencies. 41 Originally, the Greater Gulf projects were to be funded by the United States Department of Housing and Urban Development. By January, 1971, however, this plan was changed and funding was sought from the Farmers' Home Administration of the United States Department of Agriculture (FHA). During February, Phillips arranged for two FHA officials, S. B. Wise and W. T. Richardson, to visit Avon, New York, and to discuss with Yanowitch and David Stirling the commitment of FHA funds to Greater Gulf for the purchase of Homex modules. Wise and Richardson, however, were unable to authorize the funding commitment, a matter of some concern to Homex officials in that Homex had already chosen Merrill Lynch, Pierce, Fenner & Smith (Merrill Lynch) to underwrite a July, 1971, issuance of Homex stock. This issuance required the filing of a second registration statement with the SEC, which in turn required a certification by Homex auditors of the financial records for the fiscal year up to January 31, 1971. About that time, Homex discharged HKF and retained Peat Marwick as auditors. 42 On February 24, 1971, Phillips secured the signature of Greater Gulf's volunteer President Kenneth Caron on a series of documents, including a sales contract between Homex and Greater Gulf which was backdated to December 28, 1970. Phillips explained to Caron that the backdating was merely for funding purposes. Phillips also told Caron that the contract was the same as an earlier $100 million agreement that Caron actually had signed in December, 1970, except that it provided for fewer units. Phillips did not call to Caron's attention the absence of the contract clause requiring the modules to be manufactured in Mississippi. Phillips also gave Caron a letter from Greater Gulf to the FHA requesting a $15 million loan and a response from the FHA, purportedly signed by Richardson, committing the FHA to the loan. Caron signed the FHA response in order to accept the loan. Richardson's signature on the FHA commitment was in fact forged at Phillips' instruction by his secretary. On the next day, February 25, 1971, Schulz instructed the Homex accounting department to credit Homex with the sale to Greater Gulf of 566 modules for $6,786,900. Later in the year, still without a valid contract or a genuine government funding commitment, Homex assigned another 60 modules to the Greater Gulf project in order to boost reported year-end revenues. 43 The forged commitment letter was kept by Yanowitch and used to the benefit of Homex on three important occasions. First, it was used to assist Dr. Mauriello in arriving at an opinion regarding the propriety of recognizing income from the Greater Gulf transaction. Second, it was shown to Homex's commercial bankers. Third, it was shown to Peat Marwick on March 19, 1971, to aid them in their audit of the financial records for purposes of the approaching issuance. The Greater Gulf sale was described to Peat Marwick verbally and supported by the backdated December 28, 1970, contract. It was also supported by a contract between Greater Gulf and the U.S. Shelter Corporation (U.S. Shelter), a wholly-owned financing subsidiary of Homex, in which Greater Gulf agreed to pay a finder's fee of $300,000 to U.S. Shelter for securing the $15 million federal funding commitment. 44 Accounting Practices During the 1970-1971 Fiscal Year. 45 Three incidents during the 1970-1971 fiscal year make it clear that Homex accounting practices during that time were considerably less than straightforward. First, a significant proportion of the modular sales recorded for the first quarter was based upon the assignment of modules to purported sales with housing authorities in Clay, New York, and Southbridge, Massachusetts. These sales were reported as income notwithstanding the fact that there existed neither written contracts nor funding commitments to support the assignments. The unaudited first quarter earnings were supplied to various commercial and investment bankers, eventually leading to an offer to purchase Homex debentures. 46 Second, beginning in December, 1970, Homex maintained not only a computer file showing assignment of particular modules to construction projects, but also a special or simulation file. Formally, these files were known respectively as File I and File II; computer room employees, however, called the first file the real world file and the second file the Mickey Mouse file. Mr. Wilbur Rumley, Scheduling Coordinator for Homex Operations Control, testified at trial that on File I some apartments were assigned to one project and on File II they were assigned to another. In other words, the Mickey Mouse file was used by Homex to verify to its auditors that certain modules were assigned to certain contracts, thus justifying the inclusion of the price of those modules as income. 47 Finally, just prior to the filing of Homex's 1971 registration statement, an ambiguous debt confirmation gave Peat Marwick reason to question the inclusion by Homex of $832,000 as an account receivable. Homex had reported the figure as income notwithstanding the fact that it had been spent on the so-called soft costs of constructing the Mississippi plant, costs such as architectural and engineering fees and site selection costs. Such costs may be capitalized as costs of construction. Apparently on the theory that Mississippi authorities would one day reimburse it for the expenditures, Homex reported them under accounts receivable. As a result of Peat Marwick's inquiries, Homex shifted the $832,000 from accounts receivable to costs of construction in process. 48 The 1971 Registration Statement. 49 On April 21, 1971, Homex filed with the SEC a registration statement intended to cover the sale of 1,025,000 shares of Homex common stock. This was changed by amendment on May 28, 1971, to a new issue of 500,000 shares of Homex cumulative convertible preferred. On July 29, 1971, Merrill Lynch sold and distributed 500,000 shares of Homex preferred stock at $40 per share, netting Homex $19 million. Labor Relations 50 In draft, the section of the 1971 registration statement dealing with the labor relations enjoyed by Homex summarized its various labor agreements and noted that: 51 The Company believes that the above-mentioned agreements have contributed to its present satisfactory labor relations, but it can give no assurances that it will be free of labor problems in the future. 52 The final registration statement, however, contained no caveat regarding future labor relations. Nor did it reveal the intricate investment relationships that had developed between Homex and labor and which no doubt contributed to the satisfactory labor relations. 53 In June, 1969, Homex entered into a labor agreement with the United Brotherhood of Carpenters and Joiners of America (UBCJA), the exclusive bargaining agent for Homex production employees. This in itself was a matter of some moment, for organized labor had expressed concern about the possibility that Homex-type production techniques would eliminate jobs in the housing and construction industries. Thus, Homex press releases described its relationship with the UBCJA as precedent-setting. The government, however, claimed that the relationship was more accurately characterized as cozy. 54 For example, UBCJA members and officials had, in November of 1968, helped convince the Akron, Ohio, Planning Commission Appeals Board, a municipal zoning authority, and the Akron City Council, a prospective Homex customer, that the Homex concept of housing construction was not opposed by organized labor. The coziness of the Homex-UBCJA relationship went considerably further than mere collaboration, however. The record shows that the 1971 registration statement and other reports were materially false and misleading in that they failed to disclose that Homex officials had arranged for the sale of approximately $240,000 worth of Homex common stock to seven officials and members of the UBCJA at approximately $80,000 less than the stock's market value. In addition, when the market value fell, Homex arranged for the purchase from those same union officials and members of approximately $64,000 worth of Homex common stock at approximately $136,000 above the fair market value. 55 On October 1, 1969, Homex filed its registration statement in connection with the issuance of the 1,175,000 common shares. The prospectus made the following observation on Homex's labor relations: 56 (T)he modules are manufactured and dwellings are erected completely by building trades union labor. The Company has had no strikes or interference with its production or on-site erection of its dwelling units. 57 Freedom from work interruptions as a result of labor problems is important to the continued success of the Company's business. Although the Company believes the above-mentioned agreements should contribute to the continuation of its present satisfactory labor relations, it can give no assurance that the Company and its subsidiaries will be free of labor problems in the future. 58 During the following months, conversations regarding the possible purchase by various UBCJA officials and members of soon-to-be publicly offered Homex stock were pursued. On January 6, 1970, Yanowitch asked the Homex legal department to consider the legality 11 of designating union officials as eligible to purchase Homex stock at the $16.50 issue price. 12 The department did not find such designation unlawful, but it did advise that the arrangement would, if made public, be bad for Homex's image. Despite this advice, and in anticipation of the February 19, 1970, offering, Homex submitted to Pressprich a list of several hundred names as issuer-designated subscribers, including the names of seven UBCJA officials. Kenneth Langone, President of Pressprich, questioned the propriety of designating labor union representatives as subscribers, arguing that they were people with whom Homex was supposed to have an arm's length relationship. As a result, the names were taken off the list. 59 On February 19, 1970, the Homex registration became effective, and 1,175,000 shares were sold at $16.50. Within minutes, Homex shares were being traded at $34 per share; one month later the price was up to $52 a share. David Stirling then contacted Langone and argued that the union officials should have received the stock as had been discussed. Langone, having overcome his earlier reservations, proposed backdating sales to the union representatives to the $34 per share after-market purchase price. Stirling agreed to this arrangement and instructed Charles Marshall, then his banker at the Central Trust Company in Rochester, to loan the purchase price of the stock to the union officials. Stirling guaranteed repayment of the loan under his personal line of credit, though at trial he claimed the guarantee was a forgery. In sum, on March 20, 1970, seven UBCJA officials purchased, effective February 19, 1970, and aided by a loan arranged and guaranteed by Stirling, approximately $240,000 worth of Homex stock for approximately $160,000. 60 On January 8, 1971, Homex's annual report and proxy statement were mailed. The annual report contained the following comment on Homex labor relations: 61 Stirling Homex is pleased to have been the first modular housing manufacturer to sign a national labor contract with the United Brotherhood of Carpenters and Joiners of America (AFL-CIO) for both in plant production and on-site installation. 62 A few days earlier, Homex's chauffeur, William McCann, acting on Yanowitch's instructions, cashed six Homex checks for $11,500. These checks were payable to cash, and had been issued on the basis of false travel and entertainment expense vouchers. The money was used to pay the interest due on the Central Trust Company loan to the union officials. There was no mention of this in the annual report or proxy statement. 63 Finally, in November, 1971, Homex went even further to foster its precedent-setting labor relations. By then, Homex stock had begun to fluctuate between $15.00 and $18.00 per share. William and David Stirling, along with Yanowitch, arranged for the repurchase of the union officials' stock at $34.00 per share, the amount for which the stock had been originally purchased. We note that the labor contract with Homex expired at the end of September, 1971, and a new three-year contract was successfully negotiated. Kece, Reseac and Route 57-31 Revisited 64 The original 1971 registration statement included the following representation regarding the Kece, Reseac and Route 57-31 land transactions: 65 During the fiscal year ended July 31, 1969, the Company sold two parcels of undeveloped land (Kece and Reseac) and during the seven months ended February 28, 1971 it sold one parcel (Route 57-31). Trade sales included $750,000 for the year ended July 31, 1969 and $1,822,723 for the seven months ended February 28, 1971 in respect of these sales, which resulted in net income for the respective periods of about $187,000 (18% Of the total net income) and $556,000 (35% Of the total net income). All the sales of undeveloped land provided for deferred payment of part of the purchase price. 66 In addition, under Notes to Consolidated Financial Statements, the registration statement described in some detail the Kece, Reseac and Route 57-31 arrangements as Long-Term Receivables. 67 The descriptions in the Notes had been brought about by pressure on Homex from HKF to disclose the nature of the transactions more accurately. In turn, these descriptions prompted the SEC to inquire into the arrangement and, eventually, to require an even more detailed disclosure regarding the Route 57-31 arrangement. Despite various intentional misrepresentations by Homex, the SEC ultimately prohibited inclusion of the $2,100,000 Route 57-31 sale as income. The registration statement as finally amended and filed left the Kece and Reseac representations the same, but reported the Route 57-31 transaction under Inventories as follows: 68 The Company has entered into a contract to sell a parcel of land with costs of $673,017 for a price of $2,100,000. The Company has received a down payment of $210,000 which has been accounted for as an option deposit. 69 Thus, Homex was finally forced to acknowledge that land transactions of the sort it was engaged in were not honestly characterizable as sales and income but rather as contracts for possible subsequent sale in other words, option contracts. Accounting Practices Revisited 70 Both the draft and final 1971 registration statements represented that Homex recognized the sale of modules when the units are manufactured and assigned to specific contracts. This prompted the SEC to inquire whether income was being recognized too far in advance of the date of billing to customers. Homex, through Schulz, responded by letter with the following information:When the following conditions have been met, the Company records as sales and charges costs with the related costs of modules manufactured. 71 1. The Company must be designated by the local housing authority, non-profit sponsor or other agencies as the contractor for the project. This designation is supported by a formal commitment from the customer to the Company. 72 2. The customer must have obtained and submitted evidence to the Company that a commitment of monies to fund the project has been obtained from the appropriate governmental agency under which the project has sponsorship. 73 3. The numbers and types of modules and the general site plan and improvements must be identified and be the subject of the agreement between the Company and its customers. 74 4. The Company must assign the manufactured module to a specific project and physically identify the module as being assigned to and reserved exclusively for that specific project and customer. (At the present time this identification is physically attached at the earliest stage of the manufacture of the module.) 75 5. The module must be completed and be ready for shipment to the customer. 76 When all these events have occurred, and only when all these events have occurred, does the Company recognize income. 77 (emphasis added). 78 Clearly, all these events had not occurred with regard to the Southbridge, Massachusetts, and Clay, New York, projects. Similarly, they had not occurred with regard to the Mississippi project. The Mickey Mouse file hardly substantiates Homex's claim that it relied solely upon the existence of these events for income reporting. In fact, large scale reassignment of modules to various contracts seems to have taken place whenever it met Homex's needs. Had this practice been disclosed, it would have been clear to Peat Marwick that, as one of its auditors testified at trial, 79 Homex was not producing to a specific customer order and exclusively reserving modules for contracts, but rather manufacturing for inventory and therefore instead of having those units in sales, those units would have been in inventory, which would have had a significant effect on the income recognition and the portrayal of the balance sheet. 80 The 1971 Annual Report. 81 On October 8, 1971, Homex mailed its Annual Report to stockholders. As might be expected, it mentioned very little of the story just told. 82