Duff & Phelps Credit Rating Co. (DCR) and Fitch IBCA recently have launched an investigation into the financial records and activities of healthcare receivables company National Century Financial Enterprises Inc. (NCFE) in response to a series of anonymous letters received separately by both DCR and Asset Sales Report.

The three letters, apparently sent by the same author to DCR analyst Jeff Orr over the span of one year, received separately by ASR two weeks ago, contain allegations and tips implying that NCFE is involved in a pattern of fraudulent activity connected with either non-existent or misappropriated receivables.

Separately, Dublin, Ohio-based NCFE and its chief executive officer, Lance Poulsen, were recently named as defendants in at least two lawsuits in as many states with allegations including racketeering, money-skimming from payments of receivables, the diverting of funds into private bank accounts and "a pattern of abusive, wrongful and unfair practices" in connection to the handling of receivables related to the asset-backed financing of certain healthcare providers.

The first two letters, addressed to Jeff Orr and dated April 26, 1999, and July 16, 1999, state that NCFE "operates outside the scope of its indentures and normal business practices." Further, the writer of the letters alleges that "it is estimated that approximately 50% or more of the $2 billion portfolio is either worthless or non-existent."

According to Orr, the third and final letter, dated March 29, 2000, was received by ASR but not by DCR, despite the fact that the ASR copy was addressed to Orr. This letter gets more specific, urging a third-party examination of low-income healthcare provider Lincoln Hospital, based in East Los Angeles and part of a larger system of clinics managed by MediManager. The letter says that Lincoln, which has a longstanding relationship with NCFE as a seller in NCFE's securitization programs, is "just the tip of the iceberg," and urges DCR to look into how many valid receivables are available as well as how many different investment vehicles contain receivables from Lincoln, and for how much.

Another source at DCR who wished to remain anonymous - and who resigned to start work at a new company shortly after speaking to ASR - seemed to recognize the name Lincoln Hospital, and asserted that the triple-A ratings given to NCFE's deals were based on "historical collections and the ability to service the receivables."

"With respect to the specifics and the generalities in these letters, obviously we think they are all unfounded and untrue, and it really is an unfortunate byproduct of the success of the company," said Roger Faulkenberry, vice president and director of securitizations at NCFE. "We have worked pretty hard for 10 years here at this company to establish ourselves in this position...We think that our track record speaks for itself and the fact that we have had multiple outside parties reviewing our transactions as well as our financial records really gives us strong footing to say these allegations, to the extent that you can call them allegations - given how general they are in nature - are completely unfounded and untrue."

DCR and Fitch Respond

Both Duff and Fitch have assigned triple-A ratings to the majority of securities issued through NCFE's "NPF" program of securitizations over the last several years. It should be noted that only DCR, not Fitch, received the aforementioned anonymous letters directly.

Now in receipt of all three letters - and apprised of separate, unrelated lawsuits against NCFE currently filed in Delaware and Massachusetts that contain similar allegations of fraudulent handling of receivables payments, both rating agencies, and deal underwriter Deutsche Bank Alex. Brown, have each launched investigations into the matter, receiving information in bulk from the NCFE in the hopes of proving its innocence.

"We're having a series of conversations with the company providing us with a ton of information as we try to look into this to determine if there is any fire to the smoke," said Kevin Duignan of Fitch IBCA. "At this point we have not been able to determine that there is, to any degree. It will be another week or two before we come to any conclusions.

"The company has been unbelievably cooperative," Duignan said. "There is no reason to believe that the allegations are true at this point. Making a company prove its innocence is not an easy thing to tell your client."

"We received the first two letters last year and we made inquiries and at the time we concluded that rating action or doing something about it was not warranted," added DCR's Orr. "Now that we have in our possession the third letter, which is more specific, we are further investigating the matter."

Alex Manson, the investment banker at Deutsche Bank who has worked with NCFE, added: "We cannot afford to overreact here or underreact. We have to do the right thing. At this point, it is hearsay. The company's attitude is that they do not know of any issues, and they have nothing to hide, and they are working with us on it until we get to the bottom of it."

Manson added that the nature of NCFE's business means it's not unusual to be named in lawsuits. "But in the presence of this type of situation, we have to react, and we have to do our homework," he said. "The key question here is, how many receivables are we talking about in the scheme of things?"

Standard & Poor's Ratings Services has not rated any NCFE deals for about five years. "We looked at them years ago," said an S&P analyst. "But for various reasons - one being that we were not that comfortable - we kind of parted ways. It was due to qualitative reasons."

However, NCFE's Faulkenberry noted that S&P has never considered the healthcare sector a priority, and did not have the expertise to continue rating transactions in this asset class. Duff and Phelps, on the other hand, has been at the forefront of healthcare receivables ratings.

Moody's Investors Service, meanwhile, does not rate healthcare deals.

All of NCFE's securitizations under the NPF trustee program are Rule 144A private placements without registration rights, meaning that the SEC has no official record of the transaction. However, according to Uniform Commercial Code (UCC) filings, NCFE apparently worked with Lincoln Hospital as debtor on several transactions.

Additionally, the rating agencies usually monitor such transactions through monthly servicer reports or private placement memorandums.

"The integrity of this company is heavily scrutinized by the agencies, and deals are refinanced all the time," said a source at Credit Suisse First Boston, who acted as book runner for NCFE on all the early NPF-series deals. "Additionally, there is lots of due diligence in the course of underwriting."

The Link to Lincoln

The rating agencies are beginning their investigation by looking into the "master-indenture" arrangements and financial records related to NCFE's funding program with Lincoln Hospital in Los Angeles.

NCFE has financed Lincoln for more than seven years, buying the hospital's accounts receivables in a funding/securitization program.

"NCFE guarantees the funding program and makes sure we make payroll and claims on time, providing us with a security and a safety net that is something that is attractive to us, so it has been a good, beneficial relationship," said John Carvelli, director of the board at Lincoln.

"We are a busy hospital for low-income patients and belong to an integrated healthcare system associated with eight clinics in L.A. Our relationship with NCFE has been a big help to the hospital," Carvelli added.

NCFE funds Lincoln through its NPF series of securitizations. These series are established special-purpose, bankruptcy-remote healthcare receivable purchasing programs organized as wholly owned subsidiaries of NCFE.

The mechanism that is set up with Lincoln is analogous to the master-indenture structures set up with all of NCFE's healthcare clients (or "sellers"). It is estimated by rating agency sources that at least two securitizations, NPF-VI and NPF-XII, have some exposure to receivables bought by NCFE from Lincoln Hospital.

The Lawsuits

Two lawsuits recently filed in the Federal Court in Delaware and the U.S. Bankruptcy Court in Massachusetts against NCFE allege that an accounting system and structure overseen by NCFE contain hints of fraud or deceit. The rating agencies are now examining the overarching system set up at Lincoln Hospital, an arrangement that, at first blush, seems to be similar to NCFE's other master-indenture structures.

For all of its NPF trusts, NCFE sets up a lock box arrangement by which healthcare payors are instructed to direct their payments to NCFE's lock box, which "traps" the receivables for accounting purposes. All cash is collected by the clients (the healthcare providers) from the payors of receivables.

According to NCFE's Faulkenberry, the money "does not go through our hands, but is administered by independent third-party banks approved by the rating agencies."

The clients are forced to instruct the payors to direct these payments - cash flows from insurance companies that often pay out over a long span of time - into the lock box accounts if they participate in any of NCFE's funding programs.

"These funds don't come out of the lock box unless it is pursuant to the waterfall - that's the only way cash can come out of the SPV," Faulkenberry added. In the "waterfall" paradigm, NCFE is, in fact, at the bottom of the list - investors and the clients get payments first.

"We get whatever is left after the waterfall," noted Faulkenberry.

However, the Delaware suit alleges that for one of NCFE's clients - North Carolina-based PhyAmerica Physicians Group - NCFE was not only in charge of the lock box, but the CEO of PhyAmerica was in cahoots with NCFE and diverted funds into private accounts. All told, the complaint alleges $30 million in receivables are missing.

According to the complaint, two shareholders of PhyAmerica are suing both Steven Scott, the founder and top executive of PhyAmerica, as well as NCFE and Lance Poulsen, for allegedly orchestrating a "pattern of racketeering" by manipulating PhyAmerica's results to hide a money-skimming scheme.

NCFE provided the funding for PhyAmerica when the healthcare provider bought Sterling Healthcare Group last summer for $69 million plus $20 million in assumed debt.

The complaint goes on to allege that NCFE funded Scott's personal transactions in return for looking the other way while Poulsen diverted the money when they were supposed to be financing their receivables.

"The question here is, who is controlling the lock box?," said Jay Eisenhofer, a lawyer at the firm of Grant & Eisenhofer, which is representing the two shareholders. "So one might ask, in the case of Lincoln Hospital, how is Lincoln keeping track of this? And furthermore, can the clients match up the payments to the receivables they have in their books? Who keeps track of it - NCFE or the client?"

"It has always been NCFE's philosophy that 95% of the time the person that generates the receivables is the best person to, in fact, collect the receivables, and as a result of that philosophy, in our true sale programs, the client has the responsibility of billing and collecting," said NCFE's Faulkenberry. "The suit is frivolous and we've made a motion to dismiss it.

The Boston Case

In the Massachusetts case, Boston Regional Medical Center (BRMC) vs. NCFE, a bankrupt and shuttered hospital filed suit against NCFE, which was supposed to keep it out of trouble, and against Doctor's Community Health Care Corp. - a Scottsdale, Ariz.-based company that is allegedly 20% owned by NCFE's Poulsen - for backing out of a deal to buy the Boston facility.

The lawsuit seeks unspecified damages for 16 counts, including fraud, misrepresentation, breach of fiduciary duty and civil conspiracy, based on allegations that shortly after taking over as manager of the hospital, DCHC assumed direct responsibility for the agreement with NCFE. "Together, DCHC and NCFE assumed total control over the hospital's financial management and payment of the hospital's obligations," the complaint states.

Furthermore, the complaint alleges that NCFE wrongly demanded the assignment of BRMC receivables, which the hospital began selling in 1995 to meet expenses, as a pre-condition to advancing funds to BRMC. The plaintiff asserts that NCFE is withholding receivables which "must be disgorged and turned over to the bankruptcy state."

It should be noted that all of these allegations are simply taken from complaints lodged by the plaintiffs, and, in fact, there haven't even been responses nor a period legal discovery as of yet.

"We've looked into these lawsuits, and we are not alarmed at all, because we understand that it's extremely typical and not unusual at all in this business to be named in lawsuits," Fitch IBCA's Duignan.

"In our 10-year history, no receivables were ever sent to NCFE," Faulkenberry said. "In 90% of cases, cash is properly redirected to the lock box...Because we provide clients with competitive advance rates, clients have the incentive to make sure that balance requirements are correctly calculated...and that their own balance is reconciled to make sure they don't have too much collateral compared to our funding. All of those calculations are tied together in a multiple series of audits."

According to Faulkenberry, NCFE has eight years of audited statements - five of which are with Big 4 accounting firms - three audits a year from an independent auditor, internal procedures and rules, and severe scrutiny from the rating agencies two times a year - and outside shareholders and independent directors.

"We usually don't even respond to innuendo and anonymous letters," Faulkenberry noted. "And, I might add, since the first letter was sent, we've done $700 million more of securitizations, and we've purchased over $12 billion of receivables since we were founded. An awful lot of people keep their eyes on this company."

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