DBSI used new investments to pay for operations, lawyer says

Editor’s note: An earlier version of this story published Tuesday, June 16, 2009 contained errors. A court-appointed examiner did not report finding that DBSI, a Boise real estate investment company with properties around the nation, has committed fraud.

Henry F. Sewell, an Atlanta lawyer representing the examiner, told a bankruptcy judge June 9 that the examiner had found that DBSI appeared to have relied on new investor money to pay for operations since 2006 or earlier. Also, Sewell’s comments were incorrectly attributed to the examiner.

The story below has been re-edited to correct these mistakes and to reflect some additional details in a subsequently released transcript of the June 9 hearing. _____

© 2009 Idaho Statesman

The preliminary findings are the latest blow to investors in the Boise company, which filed for bankruptcy last November as real estate values collapsed and lending dried up in the nationwide financial meltdown.

DBSI opened in 1980, and through investments in real estate, technology and securities, it grew to a multibillion-dollar company with holdings in almost every state, including Kastera Homes and several shopping centers in the Treasure Valley.

Before it filed for bankruptcy, DBSI controlled hundreds of commercial properties around the nation and had more than 8,500 investors.

In a federal bankruptcy court hearing June 9, a lawyer for a court-appointed examiner updated the judge on the examiner’s findings so far.

The lawyer, Henry F. Sewell of Atlanta, said DBSI has relied on new investor money to fund operations and obligations since 2006 or earlier, and that its financial problems stretch back to the late 1990s, according to a transcript of the hearing.

Idaho securities regulators previously characterized DBSI’s real estate investments as a Ponzi scheme. In a Ponzi scheme, money from new investors is used to pay off earlier investors. The scheme falls apart when clients start trying to pull their money out and there aren't enough new investors to replace the money.

Neither Sewell nor any other participants in the June 9 hearing said DBSI had engaged in a Ponzi scheme or other fraud.

Sewell said the examiner’s investigation is still in its early stages.

“Some of the preliminary conclusions we reach may not turn out to, in fact, be true, but this is what we know today, essentially,” he said.

But Sewell said the examiner, Joshua Hochberg, a Washington, D.C. lawyer in the same law firm as Sewell, said there were “numerous failures in recordkeeping” that challenged investigators and raised questions about how DBSI handled some transactions.

In addition, the examination so far has found evidence of insider transfers and databases the examiner previously didn’t know about.

David Baldwin, a lawyer who represents the Idaho Department of Finance in the bankruptcy case, told the Idaho Statesman that the database might contain more records of the interconnectedness of DBSI’s 800 business entities — mostly holding companies that contained investments in real estate, securities and technology.

Of interest to the examiner and to DBSI’s creditors is whether money has been moving from bankrupt entities, which are subject to court scrutiny, to DBSI-controlled entities that are outside the court’s purview because they haven’t filed for bankruptcy protection, Baldwin said.

Up to this point DBSI has tried to keep the assets of more than 600 such companies in its control safe from scrutiny, while about 180 are included in the bankruptcy. Most of the companies are limited liability companies or holding companies. They have names like DBSI 2001A Funding Corp. and DBSI/Western Technologies LLC.

DBSI has not answered calls to its offices in months.

The creditors are questioning DBSI’s ability to manage the liquidation of assets fairly.

“An entire universe” of entities “with untold assets have been obscured and excluded from these proceedings,” the creditors told the court in a motion filed last week.

The motion lists millions of dollars in transfers from and among DBSI entities, illustrating the company’s tangled finances, which involve many nondebtor entities, including Eagle-based Kastera Homes LLC.

Kastera shuttered operations shortly after DBSI declared bankruptcy but remains outside the bankruptcy proceedings.

The creditors’ motion says Kastera was loaned $9.1 million by two other DBSI companies that are part of the bankruptcy.

The motion says the “perversely overlapping insider ownership” of these entities creates a conflict of interest for DBSI’s management, making it impossible for them to fulfill their fiduciary duty to design a Chapter 11 plan that protects all parties. DBSI filed for bankruptcy protection under Chapter 11 of the U.S. Bankruptcy Code, which protects a company from most creditors while management creates a plan to repay its debts and reduce costs, or in this case liquidate the assets.

“The committee (representing creditors) has uncovered examples of the debtor’s mismanagement ... carelessness and disregard at best, and perhaps much worse,” the motion says.

The creditors asked the judge to let them submit an alternative to DBSI’s Chapter 11 plan.

Their plan would sweep all DBSI entities into the proceedings and allow the court to examine the books of the entire conglomerate, not just the portions DBSI chooses.

“What we are interested in knowing is if there is money in those non-debtor entities that could be used to compensate some of the injured parties,” Baldwin said. “They had technology companies, securities companies, real estate companies, and they are presumably still solvent, since they haven’t filed for bankruptcy.”

If the judge denies their request to allow a competing plan, the creditors requested he appoint a trustee, a neutral third party who would assume control of the company’s operations while it is in bankruptcy.

Meanwhile, a lawsuit filed against DBSI by the state is on hold pending release of the examiner’s full report, which could come later this summer. The lawsuit seeks nearly $10 million in damages plus fines.

The June 9 hearing took place in Delaware, where DBSI is incorporated. The bankruptcy judge appointed Hochberg in April at the state’s request.