Transaction Type: Recurring examination of a $150MM warehouse line of credit associated with a company that provides financing of medical equipment ranging from small- to large-ticket goods. The warehouse facility was at the bottom of a complex debt structure that included several securitized pools of collateral with various lending institutions.

Significant Finding: As part of the testing for the examination, we requested an asset and lease finance contract report for the entire entity instead of a report that would support the warehouse facility on its own. In the past, such a reconciliation was not accommodated by the company. It was assumed that if proper assignments and releases of collateral with the collateral custodian had taken place, it would be impossible to have collateral pledged to more than one lender. But a simple sort of this report, and comparison with other similar reports supporting the various servicing reports and borrowing base reports, revealed several large leases that were duplicated between the warehouse line and one or more of the securitizations. When questioned, the company at first stalled, but eventually a clerk validated our results. The clerk provided written evidence that an override to the system had been requested by a senior manager in the accounting department.      Removing these duplicate leases revealed a shortfall of approximately $60MM. To corroborate our results, we tested the collateral custodian’s records and discovered that several leases had been moved between not only the warehouse line we were testing, but also two other undisclosed warehouse lines and the various securitized pools. This was a form of collateral kiting that resulted in substandard leases moving between facilities for the purpose of creating borrowing availability.

During our file review, we discovered several leases in which the lease terms (i.e., interest rate, term, and balloon payment) didn’t match the terms on the company’s system. The company had simply changed the terms to fit the parameters of the loan and security agreement. This way, several large leases could be included as available collateral when in fact their terms would have excluded them from the allowed leases under the prescribed definition in the loan and security agreement. These and other leases and loans to parties associated with senior managers were excluded, which provided for another $40MM in deficient collateral.

Impact on Transaction: Upon learning of the shortfall in collateral, the lead lender for the warehouse facility we were examining terminated lending. This began a domino effect that resulted in the cross default of several other of the company’s credit facilities. Turnaround firms were engaged and we assisted in further outlining management actions and valuing the collateral to determine what could be salvaged should liquidation become necessary. The warehouse facilities’ lenders eventually took a settlement of their amount owed and wrote off approximately one-third of the loan. Federal investigators and a court-appointed investigator used our initial findings as the basis for their report. The company entered into bankruptcy about two weeks after our finding and is currently being wound down and liquidated. It is estimated that in the end, the lenders to this firm will post losses in the tens of millions.