The Daily Caller, a Washington D.C. based news site, recently reported allegations of bribery and corruption within the United States Department of Justice. This arises from a situation involving previous allegations of “financial irregularities” within the National Rural Utilities Cooperative Finance Corporation (CFC), dating back to the early 2000s.

CFC was formed in 1969 to help rural electricity cooperatives get access to private funding.  In 1987, the Rural Telephone Finance Cooperative (RTFC) was created as an affiliate of CFC to help rural communities finance their telephone infrastructure. Much of the money loaned out comes from the federal government, with a reported $5.1 billion coming from the U.S. Department of Agriculture and the Federal Agricultural Mortgage Corporation between July 2005 and February 2010.

Allegations of Financial Improprieties

It is alleged that between 2000 and 2005, CFC

“…inflated its own balance sheet with millions of dollars in nonexistent operating income. At the same time, it deflated RTFC’s worth, essentially siphoning money away from a member co-op that it created.”

Why might this have been done? CFC is a non-profit, tax-exempt organization. RTFC is not tax-exempt,so it is alleged that the money shuffle was done to fraudulently reduce the profits of RTFC and avoid income taxes.

How could it happen?  CFC and RTFC share an executive staff, and this allegedly makes improper transfers easy to manage.

Member Investigation

Jeffrey Prosser, a telecommunications investor who borrowed around $100 million from RFTC started asking questions. He suspected that CFC was misusing RTFC member’s funds, and brought his concerns to management. He says the result was CFC pushing to foreclose on his loans. Although RFTC was the lender of funds to Prosser, CFC manages the lending activities of RTFC, and was therefore able to push for the foreclosure proceedings.

Prosser and others continued to try to hold CFC and RTFC accountable for what they believed was the use of fraudulent financial statements to secure continued federal funding. A False Claims Act complaint was filed by John Raynor, who worked with Prosser to investigate CFC and RTFC. The case was dismissed last year with prejudice, but that decision is currently being appealed.

Bribery and DOJ Corruption?

While the wheels of justice were turning ever so slowly, the allegations of bribery came to light. Prosser’s company Innovative Communications Corporation was forced into bankruptcy and he was removed as CEO. Prosser’s former personal assistant was a witness in the bankruptcy who turned on Prosser. It was alleged that the assistant was essentially being bribed, since his legal fees were being paid by others involved in the bankruptcy. It was also alleged that bribes were paid to Department of Justice investigators and officials in the U.S. Virgin Islands, and that Attorney General Eric Holder was aware of the bribes but looked the other way.

According to The Daily Caller, the DOJ investigated Prosser (who was eventually cleared), and then turned their attention to CFC.  The Daily Caller reportw that the DOJ discovered that members of its investigative team were “compromised” and “corrupt”. In a follow-up story, the Daily Caller reported that the Department of Justice denied any knowledge of alleged bribery of investigators or corruption.

CoServ Loans

With all of these allegations of misconduct, I wondered what else might lie beneath the surface of the financial statements. I had to look no further than loans made by CFC to Denton County Electric Cooperative, dba CoServ Electric.

CFC reported in its 10-Q for the period ending February 28, 2001 that $889 million in loans were outstanding to CoServ. The loans to CoServ were generating approximately $5 million per month in interest income, suggesting an annual interest rate of 6.75%.

In March 2001, CoServ and CFC entered into a Master Restructure Agreement for $888 million owed to CFC, and CFC provided additional funding to CoServ. As of May 31, 2001, CoServ owed $914 million to CFC for the restructured loans, and $12 million for other loans.

On November 30, 2001, CoServe filed for Chapter 11 Bankruptcy for its telephone and cable subsidiaries, and CFC filed an 8-K on December 3, 2001 reporting $981 million in loans outstanding to CoServe as of August 31, 2001, with $947 million of that total under the restructure agreement.

On February 1, 2002, CoServ filed for Chapter 11 bankruptcy for additional subsidiaries, and the two bankruptcy filings were consolidated.

On June 24, 2002, a joint plan of reorganization of CoServ was filed, and CFC disclosed in an 8-K that “CoServ’s debt obligations will be restructured in the principal amount of $601 million  to be paid quarterly over 35 years yielding an average rate of 3.06%.”

On July 25, 2002, an Amended Joint Disclosure Statement was filed with the bankruptcy court regarding the money owed by CoServe to CFC. The statement summary indicated that CoServ would emerge from bankruptcy with “… its Creditors paid 100%.” However, in the body of the statement, it says:

“Pursuant to the Plan, a significant portion of the outstanding indebtedness of the Debtors is being satisfied at a discount.”

And:

“Pursuant to the Plan, the aggregate outstanding indebtedness of the Debtors will be substantially reduced.”

And:

“The Debtors estimate that the total amount of cancelled debt under the Plan will be over $232,000,000.00”

By now you should be asking yourself how it is possible to pay creditors 100%, while at the same time having debt canceled in the amount of $232 million.

It gets more interesting.

Restructured Note

As of May 31, 2002, CoServ owed more than $1 billion to CFC. CFC received collateral (cash and other valuable assets) in the bankruptcy, totaling something in the neighborhood of $390 million. That reduced the CoServ balance accordingly. There was a balance remaining of an estimated $600 to $609 million. What happened to that?

In the Restructured Note Agreement between CoServe and CFC, CoServ was directed to begin regular payments on the debt to CFC in the first calendar quarter following the effective date. The payments were to be applied to interest and principal. The note agreement for the restructured loan said that the original principal amount was $591 million, with an interest rate of 3.06% over the term of the loan. Yet other documents included with the Joint Disclosure statement seem to contradict that.

Exhibit C of the Joint Disclosure Statement laid out projected income statements, balance sheets, and statements of cash flows. Interest rates for the loans were noted, and the “CFC Debt” under the 2002 column was shown as $361.9 million, and labeled as net present value of the end of year balance.  Total long-term debt on the balance sheet was projected at $373.4 million as of the end of 2002.

Under Generally Accepted Accounting Principles (GAAP), long-term debt is to be valued at the present value of the future payments. It appears that CoServe may have been attempting to recognize the debt accordingly. The projections showed approximately $24.4. million of  interest and principal payments each year, with almost all of that applied to interest on $362 million at a rate of 6.75%.

In CFC’s 10-K for the period ending May 31, 2003, it disclosed loans outstanding to CoServ totaling $628 million, with an interest rate of 0%. Under GAAP, long-term notes receivable are to be valued at the present value of future payments to be received. You see this is the same method under which CoServ was to book the debt, so it stands to reason that both organizations should have booked the same numbers for the outstanding loans.

Yet now we have four different disclosures on the same set of loans as CoServ comes out of bankruptcy:

• $591 million at 3.06% (note agreement)
• 362 million at 6.75% (projected balance sheet)
• $601 million at 3.06% (CFC June 2002 8-K)
• $601 million at 0% (CFC May 2003 10-K, with principal rolled back to the date of the joint disclosure)

CoServ booked a payable of $362 million, while CFC had on its books a receivable of $628 million as of May 31, 2003. Why was there a difference of $266 million, which coincidentally made both entities look better? CoServe showed liabilities that were $266 million lower. CFC showed assets that were $266 million higher. Both win!

Normally, companies don’t know (or care) how other companies record their transactions. In this case, however, there was a joint disclosure statement made by CFC and CoServ together. Both organizations knew the numbers, yet recorded them vastly differently… in a way that improved the financial statements of both entities.

Follow the Bouncing Ball

Let’s follow the bouncing ball through the CFC 10-Ks filed for each year ended May 31, which show the following CoServ loan balances:

2003 $628 million balance

2004 $618 million balance ($10 million decrease)

2005 $594 million balance ($24 million decrease)

2006 $569 million balance ($25 million decrease)

2007 $545 million balance ($24 million decrease)

2008 $519 million balance ($26 million decrease)

2009 $491 million balance ($28 million decrease)

2010 $462 million balance ($29 million decrease)

2011  $434 million balance on restructured loans with no borrowor specified, but believed to be CoServ ($28 million decrease)

What happened?

Remember that CoServ disclosed payments of $24.4 million per year with almost all of that going to interest. Now we see that CFC booked principal decreases of $24 million or more  per year (with the exception of 2004) on the same loan, and booked no interest. Both entities can’t be booking this correctly, so which is wrong? Or maybe both of them are wrong?

Ultimately, CoServ appears to have booked a $362 million note with an interest rate of 6.75%, and annual payments of $24.4 million going almost solely to interest. It appears that CFC should have written down the loan balance to around $362 million as well. But it didn’t.

Why not?

At the end of fiscal 2003, CFC showed $15.2 million in profits from operations. An immediate write-off of $266 million pursuant to the bankruptcy would have left them with operating losses of $251 million  for the year.

What’s an electric cooperative to do?

In this case CFC appears to have kept the loan on the books at full value (with no write-down) and pretended that the interest rate was 0%.  When CoServ made its annual payments of $24 million, CFC applied all of it to principal.

Thus, instead of taking the big write-down in fiscal 2003 and then recognizing interest income of $24 million each year…. CFC took no write-down in fiscal 2003, did not recognize any interest income in future years, and simply reduced the principal of the loan by the full mount of the payments of $24 million each year. By about the end of fiscal 2013, CFC should have a loan balance that is almost equal to what CoServ has on its books, and all is right with the world.

It appears that CFC should have taken the write-down in fiscal 2003. It didn’t, because it didn’t want to recognize those losses and have operations severely in the red. Is there any other explanation for why CFC didn’t take the write-down? If one exists, I’m not aware of it.