ABS investors in DVI Inc. may face their worst fears, as allegations of significant instances of fraud have surfaced. Independent examiner R. Todd Neilson, a CPA and partner at Neilson Elggren LLP, alleges that DVI executives knowingly "double-pledged" assets and used "round-trip financing" to manage collateral performance. In addition, DVI repurchased ineligible collateral from its trusts and restructured non-performing loans and leases to appear as current, according to Neilson.

Some of these alleged "performance boosting" strategies have appeared in other notable market failures. Of course, National Century Financial Enterprises takes the proverbial cake, as there seemed no limit to steps taken by certain executives at the company to mask the true performance of the NPF deals. Other less extreme examples include allegations that franchise issuer Enterprise Mortgage Acceptance Corp. was lending to its distressed borrowers so that they could stay current on already securitized loans.

A common thread is a reliance on securitization for growth and the apparent ease in manipulating performance indicators. As for DVI, Neilson surmised that the company was perusing an overly aggressive growth strategy outside of the U.S., under the guidance of DVI Chief Executive Michael O'Hanlon. The lack of liquidity options in other aspects of the capital markets left the ABS market as the only bastion for which DVI to fund this growth.

In order to maintain access to the securitization market, O'Hanlon set forth guidelines designed to minimize delinquencies, and ultimately chargeoffs, the report finds. Under orders from O'Hanlon, DVI took what Neilson called an "aggressive approach to the assessment and write-down of impaired loans."

"This formal adherence to the structural details of accounting treatment without the benefit of looking at the entire transaction as a whole is an opiate that lulled DVI accounting personnel into thinking the accounting treatment was actually reflective [of its ABS]," Neilson pens.

In addition to lending on an unsecured basis to troubled obligors so that lease payments could be made - "round-trip financing" - instances were found where DVI would actively position quasi-subsidiaries to take over floundering operations of its lease obligors.

Cited in the report are three companies that, under certain accounting standards, could be considered units of DVI. Under the direction of Deloitte & Touche, which also is criticized by Neilson, DVI applied the SFAS 114 accounting standard to its operations (see related story).

The three "relationship accounts" disclosed in a recent conference call hosted by new servicer US Bank Portfolio Services, were apparently Dolphin Medical, OnCure and PresGar Imaging, which are described as " special-relationship companies" within the examiner's report.

These three are both lease obligors in numerous DVI ABS pools (with multiple obligations in some cases) as well as unsecured borrowers from DVI's Business Credit unit. These "special-relationship companies" are delinquent on both their unsecured debt and their lease payments (See charts, p. 11-12).

While not de facto units of DVI, the company reportedly had equity stakes in them, as well as personal relationships with executives at the companies. Although Neilson was unable to confirm any official equity ownership on behalf of DVI, he writes that O'Hanlon "stated on a number of occasions that DVI possessed an ownership interest in a number of (its relationship companies operations)."

In fact, on June 6, 2002, he found that during a DVI board meeting, financial advisors UBS Warburg had suggested DVI consolidate these companies onto its balance sheet, but "provisionally determined that these companies were of negligible value, especially given how highly leveraged they were."

Also, a personal relationship of O'Hanlon's apparently led DVI to lease equipment to a company that would raise eyebrows of any potential investor in a medical-equipment lease ABS: New York recording studio The Hit Factory, owned by a personal friend. The Hit Factory is currently over 180 days past due on two of its obligations.

Personal relationships aside, DVI's allegedly fraudulent cashflow management had ABS investors worried for months. In order to keep required loan reserves at a minimum, DVI frequently manipulated delinquent contracts, as a curing method. "The corporate dogma of resisting write-offs by any measure," Neilson writes in his report, "[was] overseen by O'Hanlon."

"The entire allowance for losses on receivables' for DVI as of June 30, 2003, was estimated at approximately $17 million. It is the Examiner's opinion that the appropriate reserve for loan losses at that period should have ranged from $75 million to $120 million," Neilson adds.

The "double pledging" of assets reportedly began in 1999, after the termination of a warehousing facility extended by Prudential Securities. As part of DVI's "aggressive" delinquency management strategy it would routinely repurchase loans eroding toward ineligibility. One such securitized loan, to Med Cap Texas and Oregon, was about to become aged-out, and needed to be repurchased for $35 million before the August 10, 1999 servicer report due date.

Fifteen million short of the $35 million needed to fund the buyout, CFO Steven Garfinkel suggested that DVI pledge ineligible collateral to a warehouse vehicle administered by FleetBoston Financial. At its greatest level, in February 2003 - roughly six months prior to its Aug. 15, 2003 bankruptcy filing - DVI's "out of compliance position" sat at over $102 million, the Examiner's report said.

Neilson also discovered that, according to Garfinkel, DVI fraudulently pledged assets to Fleet believing that "Fleet would probably not discover the problem until January 2000," at which time, the company would have raised additional equity funds and resolved its "out of compliance position."

As for the legal implications, the report contends that "there is clear, credible evidence that O'Hanlon (who was also a DVI director) expressly or impliedly authorized the [sic] non-compliance fraud," and "was kept fully apprised of its extent and magnitude."

Furthermore, Neilson alleges that corporate officers do "not appear to have taken any steps to investigate or conduct a full inquiry of the issues that had come to [their respective] attention" and "failed to inform the Board as to the serious and credible issues."

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