State v. Sterling

• Decision Date: 05 April 2012
• Docket Number: No. 27096.,27096.
• Citation: 396 S.C. 599,723 S.E.2d 176
• Court: South Carolina Supreme Court
• Parties: The STATE, Respondent, v. John M. STERLING, Jr., Appellant.

396 S.C. 599

723 S.E.2d 176

The STATE, Respondent,

v.John M. STERLING, Jr., Appellant.

No. 27096.

Supreme Court of South Carolina.

Heard Oct. 4, 2011.Decided Feb. 29, 2012.Rehearing Denied April 5, 2012.

William W. Wilkins, Kirsten E. Small and Andrew Mathias, all of Nexsen Pruet, of Greenville, for Appellant.

Attorney General Alan Wilson, Chief Deputy Attorney General John W. McIntosh and Assistant Attorney General William M. Blitch, Jr., all of Columbia, for Respondent.

Justice PLEICONES.

Appellant was charged with three criminal offenses: securities fraud in violation of S.C.Code Ann. § 35–1–501(3) (Supp.2010); ¹ making false or misleading statements to the State Securities Commission in violation of S.C.Code Ann. § 35–1–505 (Supp.2010); and criminal conspiracy in violation of S.C.Code Ann. § 16–17–410 (2003). He was convicted of securities fraud, acquitted of making a false or misleading statement and conspiracy, and received a five-year sentence. He now appeals, alleging the trial judge abused his discretion in permitting testimony from investors, that he erred in denying appellant's directed verdict motion, and that he committed reversible error in charging the jury. We affirm.

FACTS

Appellant and several other businessmen invested in a company in the 1970s that leased railroad box cars. That company eventually declared bankruptcy, but emerged with one asset: a deferred tax asset (DTA). This DTA, which could be carried forward on a company's books to offset future profits, fluctuated in value depending on whether the company anticipated making a profit. This post-bankruptcy company was known as NRUC. In 1991, NRUC acquired a Pickens-based company, Carolina Investors, Inc. (CI).

CI had been founded in 1963, originally for the purpose of making loans to individuals purchasing cemetery plots. CI, which was funded by notes and subordinated debentures sold exclusively to South Carolina investors, eventually began making small household loans and, by 1970, was involved in non-conforming subprime mortgages. Non-conforming and subprime mortgages are made to persons who cannot qualify for regular (conforming) mortgages: non-conforming mortgages carry a higher interest rate reflecting the greater risk of default.

CI had a policy of allowing investors to redeem their debentures at any time prior to maturity upon fifteen minutes' notice, albeit at a reduced interest rate. CI's investments were not federally insured, but because it made loans to persons who could not meet the credit standards required by conforming mortgage lenders, it paid higher than average interest rates on the notes and debentures.

NRUC was subsequently renamed Emergent and later HomeGold Financial (HGFin). ² HGFin, the parent company, acquired a number of other financial subsidiaries, one of which, HomeGold, Inc. (HGInc), became a subprime lender. Thereafter, while CI continued to raise monies through the sale of notes and debentures, those funds were loaned to HGFin and its other subsidiaries, and used primarily to expand business operations and pay business expenses of those entities.

During the period 1995–97, the HGFin companies were very profitable. In 1996, HGFin went public, divesting itself of several subsidiaries and becoming a pure financial services entity. In late 1997, HGInc, the subprime lender subsidiary, lost its leader, who took much of his team with him. That loss, coupled with a worldwide credit crisis in 1998, caused HGInc to suffer enormous losses. In an effort to recover economic viability, HGFin sold most of its other financial service subsidiaries, keeping only HGInc and CI. From 1998 until HGFin declared bankruptcy in 2003, HGFin and HGInc ³ never had an operating profit.

The retail mortgage lending business relies on “warehouse lines” from large lenders in order to operate. Essentially, the warehouse lines provide the working capital for the lending business, and the stability of those lines, which is dependent upon the large bank's confidence in the lender, is critical to the mortgage lender's business.

In its efforts to keep HGInc operational, with the hope it could repay to CI all the monies loaned by CI to HGInc (the intercompany debt), HGFin shrank both the number of subsidiaries and the operational aspects of HGInc. Eventually, HGFin began to look for a merger partner for HGInc in order to save the business. After several merger prospects fell through, HGFin settled upon a Lexington, South Carolina, subprime lender called HomeSense, which was owned by Ronald Sheppard. Appellant, who at the time of the 2000 merger between HomeSense and HGInc was CEO of both HGFin and HGInc, chairman of the board of both HGFin and HGInc, and on CI's board, was the leading proponent of the HomeSense merger.

The HomeSense–HGInc merger was not a success. First, due diligence completed after the merger demonstrated that HomeSense had significantly overstated its net worth. HGInc and Sheppard subsequently canceled a mutual indemnity agreement in exchange for Sheppard's remaining a guarantor on certain HomeSense debts. Second, Sheppard proved to be an abrasive leader whose leadership style and aggressive accounting maneuvers caused a number of HGInc and HGFin officers and executives to leave. Sheppard also placed personal expenses on the company books using HGInc to subsidize his extravagant lifestyle.

After the merger, appellant ceased to be an employee, but remained as chair of both the HGFin and HGInc boards, and remained on CI's board. He continued to be supplied with an office, an administrative assistant, and a salary. Over the next three years, the financial decisions made on behalf of HGInc resulted in numerous resignations by CFOs and others. In addition, the HGInc–HomeSense merger permitted HGInc's largest warehouse lender (CIT) to end the relationship.⁴ As a result of the loss of CIT's warehouse line, HGFin and HGInc's continued financial woes, and their reliance on CI investor money to stay in business, it became increasingly difficult for HGInc to obtain sufficient warehouse lines to fund its loans even as it began to increase its share of the subprime mortgage market. HGFin and HGInc continued to struggle and began moving debts and assets among the companies in order to hide its financial difficulties.

Appellant's defense was predicated in large part on the fact that the financial maneuvers that took place were approved by outside auditors, and that the Wyche Law Firm vetted and approved all of the companies' governmental filings and prospectuses. As stated above, the jury acquitted appellant of making false or misleading statements to the State Securities Division. Reliance upon the outside auditors' approval, however, is misleading. For example, the outside auditors agreed to an increase in the value of the DTA from $12 million to $22 million, as urged by appellant, in HGInc's unaudited third quarter 2000 10–Q. The auditor testified, however, that had he been told that this change in valuation was being made because HGInc needed to show a positive net equity in that quarter in order for it to renew its state mortgage licenses, that information would have “raised a red flag” and alerted him to the precarious nature of HGFin's finances.

Similarly, while the auditor was aware that CIT, HGInc's largest warehouse lender, was withdrawing its line of credit following the HomeSense merger, the auditor was never told that this secured lender had told appellant and others that it was ending the relationship because it “didn't want to be standing in front of a little old lady in Pickens County during a bankruptcy proceeding.” Again, this information would have raised a red flag for the auditors, indicating that a secured creditor was fearful of HGInc's financial worth. Moreover, there was evidence that the auditors were not informed of certain regulatory inquiries, in violation of their management letter.

Over time, the only thing keeping HGInc in the retail mortgage business was the influx of cash from CI investors. In 1999, the intercompany debt, owed by HGInc to CI, was about $67 million; in 2000, $100 million; by the end of 2001, $144 million; and at year end 2002, more than $243 million.

By 2001, the outside auditors expressed grave concerns over HGInc's ability to repay the intercompany debt to CI and its ability to remain a going concern, and they criticized a number of its accounting decisions. HGFin and HGInc continued to rely on overly optimistic projections to suggest that the companies could recover viability. In October 2001, the auditors required HGFin to obtain an independent valuation of HGInc to determine whether the intercompany debt between HGInc and CI should be reported as “impaired.” An impairment is an opinion by the auditors that the borrower cannot fully repay its debt.

On March 14, 2002, the auditors told HGFin that they would place a “going concern” paragraph in HGFin's 2001 audited financial statements. A “going concern” paragraph is an expression of doubt whether the business will still exist in a year. Moreover, the accountants rejected a valuation of HGInc for debt impairment purposes done by CBIZ, which had valued HGInc's net worth at approximately $170 million. HGFin then ordered a loan impairment valuation from Deloitte and Touche, which valued HGInc at between $130–$140 million. This valuation was accepted by the auditors, but because the 2001 year-end debt owed to CI stood at approximately $144 million, the auditors were required to report that the intercompany loan was impaired. As a result, HGFin's 2001 audited financial statement included both a “going concern” statement and a “loan impairment” opinion for the outside auditors. This impairment opinion stated that the auditors had determined that HGInc could not repay $6.7 million of the $144 million 2001 year-end debt owed to CI.

In April 2002, the CI prospectus acknowledged the “going concern” opinion of HGFin's...