Fraud! The Word Lenders Hate to Hear

“Diamond Jim” Fisk is not as well known today as Jay Gould and New York City Mayor “Boss Tweed” who were some of his business partners. But in his day as a one of the “Robber Barons” of the Gilded Age, Diamond Jim cut a wide swath and was admired for his financial buccaneering, his personal charm and his sheer chutzpah. In those days, the sharp and unscrupulous business practices of Diamond Jim, Boss Tweed and Gould went largely unchecked because of the lack of laws, the common practice of “judge -buying” and wholesale bribery of legislatures in the post-Civil War period.

After a brief period in school, he ran away at 15 years old in 1850 and joined Van Amberg’s Mammoth Circus & Menagerie. Following that, he became a salesman at the Jordan Marsh Department Store in Boston. As the 1850s drew to a close, Diamond Jim applied what he learned in the circus and the sales floor to financial speculation. At the end of the Civil War, he made a fortune when he acted on rumors about the end of the Siege of Peterburg in Virginia in March 1865, which virtually guaranteed the Confederate defeat. He sent an agent on a fast boat to London to short as many Confederate bonds as possible before the defeat was widely known in England.

Diamond Jim and Gould took financial scheming to new heights, forging an open alliance with Boss Tweed during their battle with Cornelius Vanderbilt for control of the Erie Railroad — known as “The Erie War.” To secure their grip, they installed Tweed as a director and, in return, he pushed through legislation that favored their railroad empire.

Due to the struggle to keep Cornelius Vanderbilt from taking over their interests in The Erie Railroad, Gould and Diamond Jim needed liquidity. In August 1869, they began to buy gold — attempting to illegally corner the gold market. Gould used his close relationship with President Ulysses Grant’s brother-in-law to influence the president and his secretary general to stop the weekly sale of gold by the U.S. Treasury. By influencing the supply of gold, Diamond Jim and Gould hoped to corner the gold market.

The gold corner speculations culminated in the financial panic of Black Friday on Sept. 24, 1869, when the greenback (cash) premium over face value of a gold Double Eagle fell from 62% to 35%. Diamond Jim and Gould made a small profit from that operation by hedging against the corner as it was about to collapse but lost it in subsequent lawsuits. However, the gold corner established Diamond Jim and Gould’s reputations in the press as all-powerful figures who could drive the market up and down at will. Favored by “Tweed-owned judges,” the conspiratorial partners escaped prosecution, but the months of economic turmoil that rocked the United States on the heels of the failed gold corner proved ruinous to farmers and bankrupted some of the most venerable financial institutions on Wall Street.

During this time in New York City, Diamond Jim had a relationship with Josie Mansfield, who was considered a voluptuous beauty by Victorian standards of female desirability. Diamond Jim housed his mistress in an apartment several few doors away from The Erie Railroad headquarters on West 23rd Street and had a covered passage built which linked the back doors of the headquarters and her apartment building. His wife, Lucy, lived in Boston. Diamond Jim’s relationship with Mansfield scandalized New York society.

Fast forward to Hauppauge, Long Island in 1981.

Warning Signs: A Byzantine Capital Structure

In the early 1980s, lenders didn’t know much about Medhi Gabayzadeh and Nourollah Elghanayan other than Elghanayan had been a successful Long Island developer of commercial real estate. The pair had set up American Tissue, a producer of paper products in 1981, with Elghanayan furnishing much of the initial capital and Gabayzadeh responsible for running the daily operations. The families of the two men split ownership 50/50.

Using mainly bank loans, they bought distressed paper mills, a strategy that dramatically escalated in the late 1990s. The company’s biggest acquisition came in 1999 when it bought the pulp mill in Berlin, NH and a paper mill in nearby Gorham for $45 million in cash and assumed debt from Crown Vantage, which later filed for Chapter 11. By 2000, American Tissue’s empire stretched from Oregon to New York and included eight mills capable of producing 919,000 tons of pulp and paper annually with eight plants and 12 distribution centers. With 6% of the North American tissue market, the company trailed only Georgia-Pacific, Kimberly-Clark and Procter & Gamble. The company reportedly earned $24 million on $494 million in sales for the fiscal year ended Sept. 30, 2000.

The owners apparently were not content with being the fourth-largest tissue company in the U.S.

Gabayzadeh built a Byzantine holding structure around the operation. American Tissue held its assets through 26 subsidiaries that had 40 different bank accounts. The company itself was owned by an entity called Middle American Tissue, which had no other assets and which, in turn, was owned by Super American Tissue, a holding company controlled by the Gabayzadeh and Elghanayan families. The financing needed to run this sprawling network was significant. By 2000, American Tissue secured a $145 million credit line with a syndicate led by LaSalle Bank and placed $165 million of bonds yielding 12.5% via DLJ Merchant Banking Partners, the private equity arm of the investment banker, rated B by Standard & Poor’s.

By this time, Gabayzadeh had built up a labyrinth of 45 companies with 100 bank accounts described as affiliates of American Tissue but held apart from it by the Gabayzadeh and Elghanayan families. As a result, the affiliated companies were not liable for American Tissue’s debt — even though, creditors later claimed — the affiliates benefited by receiving financing from American Tissue. These affiliates owned paper mills, machinery and two divisions of American Pad & Paper, a bankrupt Dallas-based stationery supplier that had been bought for $67 million in cash and assumed debt in 2000. The fact that there were so many separate affiliates also meant that a single entity could declare bankruptcy without dragging all the affiliate companies down with it.

Inevitably American Tissue’s balance sheet became stretched, making interest payments difficult. With only $4 million availability on its bank line, American Tissue needed an infusion of $5 million from its parent to make a January 2001 interest payment to the bondholders. To keep paying bondholders and creditors, Gabayzadeh moved to refinance the whole operation in the summer of 2001. His plan was to combine the assets of American Tissue and the affiliated companies to create a larger (and supposedly more viable) company called American Paper, and to use that entity to borrow $400 million by selling bonds with coupons as high as 12.75% in addition to $200 million in bank loans.

They almost pulled it off — Standard & Poor’s gave the new bonds a B+ rating in July 2001 and UBS Warburg prepared to manage the deal. But at the last moment the deal was shelved. S&P blamed it on market conditions. Perhaps someone figured out that the numbers at American Tissue did not add up. Indeed, two months later, in September, the company announced that its financial statements for the first three quarters of 2001, together with fiscal years 2000 and 1999, contained material inaccuracies.

Court documents later alleged that at least $15 million was siphoned from American Tissue to Super American Tissue, its ultimate parent, when customers made cash advances to Super American Tissue for inventory shipped to them by American Tissue. In a separate lawsuit funded by creditors, American Tissue accused Elghanayan of constructing a transaction that saw the company buy machinery for $3.3 million, then turn around and sell it to Elghanayan for $1 two months later.

The scheme unraveled when American Tissue filed for bankruptcy in September 2001 and began to restructure under new management. The new lenders quickly uncovered phantom sales and notified authorities, court papers said.

Creditors decided to sell the assets of American Tissue which were valued on its last quarterly filing at $569 million. Much of the equipment had separate liens on different parts — one paper making machine had 16 liens on different parts which hindered the liquidation. Bondholders from the $165 million DLJ deal such as Credit Suisse First Boston and Foothill Capital got 10 cents on the dollar. The LaSalle Bank syndicate, owed $140 million at that point, was relatively lucky, getting 32 cents on the dollar. Unsecured creditors — owed $73 million — were left out in the cold.

Lenders placed some of the blame on Arthur Andersen, American Tissue’s auditor. They funded an $800 million lawsuit by American Tissue against the crippled accounting firm, charging professional malpractice. The suit claimed that Arthur Andersen put its stamp of approval on an inflated P+L, accounts receivable and inventory while ignoring insider self-dealing.

George Psomas, Managing Director at Brooks Houghton in New York notes, “Most frauds involve fake revenue and, therefore, inflated income and accounts receivable. In addition, accounts payable remittances are often made to phony venders to syphon cash out of the company — but then some of it gets pushed back through the operating cycle to create the illusion of a much higher level of economic activity.” He adds “aggressively capitalized overhead is another play in the playbook of fraudsters.”

Warning Signs: Hollywood Lifestyle and the $1MM Model Train Collection

Founded in 1989 in Latrobe, PA by entrepreneur Gregory Podlucky, Le-Nature’s Inc. was a rising star by the turn of the century in the ultra-competitive beverage marketplace. It developed and marketed noncarbonated beverages, including flavored water and vitamin-juice drinks, employing roughly 300 workers.

In 2000, two investment funds purchased eight million shares of Le-Nature’s preferred stock for $30 million, with the right to convert into the 45% of the company’s common stock and two board seats.

The majority of the board consisted of inside directors including Podlucky, his brother Jonathan and other senior company executives.

In August 2003, the company’s “Big Four” accounting firm was completing its review of the company’s financial statements for the second quarter of fiscal 2003.

During the accounting firm’s quarterly review, LeNature’s senior executives were asked whether they suspected or were aware of any fraudulent activity within the organization. When the accounting firm audit partner posed that question to Le-Nature’s CFO at the time, the CFO candidly replied that he had significant doubts about the reliability of the company’s sales figures. The accounting firm received similar responses from Le-Nature’s chief administrative officer and its vice president of administration.

The day after communicating their concerns to the accounting firm, the three company officials submitted letters of resignation to 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.” The CFO told the accounting firm audit partner that Podlucky had repeatedly refused to provide him with documentation supporting key transactions reflected in Le-Nature’s accounting records. The departing CFO wrote to the audit partner, stating that Podlucky’s failure to provide such documentation was “an astonishing and extremely improper restriction for any executive officer to impose upon a company’s chief financial officer.”

In late 2003, Wachovia underwrote a $150 million junk-bond deal for Le-Nature’s. Some bondholders subsequently alleged that Wachovia “repped and warranted” the numbers supporting the deal. It also served as the agent for the $285 million credit facility. CIT, AIG and Pitney Bowes provided the equipment financing.

The company’s 2005 audited financial statements showed annual revenue of $275 million (it was subsequently discovered that annual revenue was $32 million — ouch!)

In October 2005, 10 private-equity firms reviewed a confidential memorandum prepared by Wachovia for the sale of Le-Nature’s and were told that a preliminary bid was $1.2 billion. In the road show, potential investors were told that the company was the 33rd largest beverage producer in the United States, with annual reported sales approaching $290 million.

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 potential buyers any 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 to force an outright sale of the company. Despite that lawsuit, Podlucky began preparing an initial public offering for Le-Nature’s. 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 IPO plans for his company were disrupted when allegations of an accounting fraud within Le-Nature’s resurfaced. He 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, by this time a regional accounting firm. Podlucky also insisted that “the financial stability of Le-Nature’s has never been stronger” 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 with Le-Nature’s. With the assistance of a handwriting expert, it was determined that certain documents for the transaction had been forged.

The Delaware court issued the requested restraining order, evicted Podlucky from the company’s corporate headquarters and appointed a turnaround management firm as CRO. Podlucky had “frantically shredded company documents before he was forced to leave Le-Nature’s corporate headquarters” according to the CRO.

Even more troubling was the CRO’s discovery that the company had been maintaining two sets of accounting records. Le-Nature’s maintained two separate accounting systems during the massive accounting fraud. One system captured the company’s actual transaction data — but only Podlucky could access this system. The other accounting system contained primarily fraudulent financial data. The company’s independent auditors were never aware of the accounting system that had actual transaction data.

Unsurprisingly, Podlucky siphoned off large amounts of those borrowed funds for his personal use. Because the stolen funds had to be repaid at some point, it was necessary for Podlucky to continually borrow additional amounts. This cycle of repaying stolen funds with new loans caused law enforcement authorities to characterize his fraud as a Ponzi scheme. Federal law enforcement authorities placed a final price tag of nearly $700 million on Podlucky’s long-running scam. U.S. District Judge Alan Bloch, in a decision that was largely symbolic, imposed a $661 million restitution order on Podlucky. That figure included the losses of the unprofitable business operations, and the funds embezzled and squandered by Podlucky and his family members.

An audit of Podlucky’s personal finances revealed that in one year, he spent $45,000 on shoes when his annual salary was $50,000. At the time he lost control of Le-Nature’s, Podlucky was building a palatial, 25,000-square-foot home near the company’s headquarters in Latrobe that had a price tag approaching $20 million. Investigators discovered nearly $30 million of jewelry in a secret room within the company’s corporate headquarters. Years later, authorities recovered additional jewelry worth millions of dollars when members of the Podlucky family attempted to sell it through Sotheby’s. Law enforcement authorities seized Podlucky’s model train collection that he had acquired for $1 million.

George Psomas comments “much like Afghanistan is the graveyard of empires, inventory can be the swamp of fraud for asset-based lenders. Some borrowers deploy sophisticated shenanigans of moving physical inventory around to deceive field examiners.” An apocryphal story in ABL circles is when the new field examiners went to the Los Angeles address where the borrower’s inventory had been moved from its original location, they discovered the address was the onramp to the San Diego 405 Freeway!

Another fascinating ABL fraud in which all of the tools from the fraudster’s toolbox were deployed by the borrower, Allou Healthcare, is chronicled in the June 2021 issue of The Secured Lender authored by Mark Fagnani.

These days, rumors are flying around Pittsburgh about a large fraud at a contract manufacturer of food products. The word on the street is that up to 75% of accounts receivable — millions — are fraudulent. Stay tuned!

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Diamond Jim’s mistress, Josie Mansfield fell in love with Diamond Jim’s business associate Edward Stokes, a man noted for his good looks. Stokes left his wife and family, and Mansfield left Diamond Jim.

Mansfield and Stokes tried to extort Diamond Jim by threatening the publication of letters written by Diamond Jim to Mansfield that allegedly proved Diamond Jim ‘s various frauds. A legal and public relations battle followed, but Diamond Jim refused to pay Mansfield anything. Increasingly frustrated and flirting with bankruptcy, Stokes confronted Diamond Jim on Jan. 6, 1872, in New York City in the Grand Central Hotel and shot him twice — in the arm and abdomen. A relatively young man of 36, Diamond Jim died of the abdominal wound the next morning after giving a dying declaration identifying Stokes as his killer. Diamond Jim’s body was laid out for public view in the Grand Opera House which he owned. Some 20,000 people came to pay their respects, with five times as many more individuals waiting in the streets to gain entrance.

Boss Tweed hoped to carve his name in the New York City history books by building “The Tweed Courthouse,” which today sits across from New York’s City Hall and kitty-corner across Broadway from The Woolworth Building. Due to Tweed’s graft and kickbacks, the construction costs of this three-story building (modest by New York City standards) ballooned to twice the cost of The Alaska Purchase in 1867. He also sought ownership of the Brooklyn Bridge in 1869. After approving the construction of the Brooklyn Bridge, Tweed and two of his partners received over half the private stock of The Brooklyn Bridge Company, the charter of which specified that only private stockholders had voting rights, so that even though the cities of Brooklyn and Manhattan put up most of the money, they essentially had no control over the project. Ultimately, Boss Tweed was indicted for fraud. Gould was the chief bondsman in October 1871 when Tweed was held on $1 million bail. Tweed was eventually convicted of fraud with estimates ranging as high as $200 million (equivalent to $5 billion in 2023) and died in jail.

Gould died as one of the wealthiest men of the late 19^th century. His fortune was estimated to be $2.5 billion in today’s dollars. He was an unpopular figure during his life and remains controversial. His home, Lyndhurst, also known as The Jay Gould Estate is a Gothic Revival mansion overlooking The Hudson River near Tarrytown. The house was designated a National Historic Monument in 1966.

Jim Gagan is a Managing Director of Trimingham Inc. and is a Certified Fraud Examiner and a CPA. Hugh Larratt-Smith is a Managing Director of Trimingham and is a regular contributing author to ABF Journal.