How an ordinary transaction became a major threat to small investment banks

B. Riley’s gamble was an ordinary acquisition of a company with an ordinary name: Franchise Group. What made the matter so toxic was the involvement of hedge fund managers with ties to failed investment companies, which prosecutors called fraudulent.

Investors are concerned because B. Reilly is a major financier of the deal and has extensive ties to hedge fund managers. New details about B. Riley’s loans to hedge fund managers point to a longer and closer relationship than previously known.

They also raise questions about whether Franchise Group should have disclosed more details about some loans years ago, when the board included two B. Riley executives.

B. Riley’s stock price has fallen about 60% since August, when the deal was completed, forcing the company to defend its involvement. In January, hedge fund manager Brian Kahn resigned as chief executive officer of Franchise Group following a flurry of news and social media posts linking him to the failed investment firm.

As part of the transaction, B. Riley acquired $281 million in stock in Franchise Group, which owns The Vitamin Shoppe and Sylvan Learning tutoring centers. The company later disclosed that it had loaned Mr. Khan’s investment company $201 million, pledging Franchise Group stock as collateral. The combined amount of loans and stock holdings exceeds B. Riley’s stockholders’ equity.

B. Reilly’s loans to Kahn go back much further than previously known. Financial statements filed with state authorities in Nevada, Delaware and Florida, known as Uniform Commercial Code filings, show the company filed at least 10 lawsuits against Mr. Khan and companies he controls from 2018 to 2023. made different loans. UCC’s filing does not indicate the amount borrowed.

Some of B. Riley’s financings to Khan were made or were made while two senior B. Riley executives served on Franchise Group’s board of directors from 2018 to 2020. Ta. Franchise Group did not disclose these as related party transactions in its proxy statement. . A possible explanation is that disclosure may not have been necessary because the franchise group itself was not participating in the transaction.

A July 2023 slide presentation by investment bank Nomura, which provided financing to B. Riley as part of the Franchise Group acquisition, included information about B. Riley’s longstanding loans to Khan. The oldest was a $37 million loan in July 2019, and by mid-2023, Mr. Khan’s loan had a principal balance of $154 million.

The current drama stems from the collapse of Prophecy Asset Management, which claimed to have overseen approximately $400 million in assets when it collapsed in March 2020. Prosecutors have called Prophecy a fraud that hid trading losses.

As an outside advisor hired by Prophecy, Mr. Khan managed most of the funds and appears to have generated most of the losses. Prophecy’s former president and chief compliance officer, John Hughes, pleaded guilty in November to conspiracy to commit securities fraud and is cooperating with Prophecy. Prosecutor.

Hughes’ attorney declined to comment. Khan, 50, is one of two anonymous co-conspirators in the case, officials said.

In the now-resolved lawsuit, Prophecy customers alleged that Mr. Khan secretly misappropriated Prophecy funds to increase his control over the franchise group. Last year, he helped take B. Reilly-backed Franchise Group private, valuing it at $1 billion.

Khan declined to comment. He has not been charged and denies his wrongdoing. In a statement to Bloomberg last month, Mr. Khan’s attorney, Douglas Brooks, said: Mr. Khan has categorically denied any knowledge of any wrongdoing by Prophecy’s executives, saying that Prophecy defrauded Mr. Khan of tens of millions of dollars and that B. Reilly and Franchise Group He said he had no business dealings with Prophecy.

Commenting on the investment in Franchise Group, B. Riley spokesperson Jo Ann McCusker said, “We remain confident in this investment proposal and believe this will be a value-enhancing transaction for our investors. “There is,” he said. has secured rights to the shares backing the loan to Khan and has priority over other creditors.

Whether B. Riley is a top priority is extremely important. According to the Securities and Exchange Commission’s lawsuit, Mr. Khan at one point pledged shares of Franchise Group to Prophecy, and Mr. Khan was referred to as “Individual 2.”

According to the SEC, Prophecy recorded that amount (worth about $200 million at the time) in its net asset value shortly before bankruptcy. It is unclear whether Mr. Khan pledged the same shares twice to both Prophecy and B. Riley.

The franchise group itself was also struggling. The publicly traded company reported net losses of $228 million over the past six quarters, primarily due to higher interest expenses.

The fallout from the deal has shaken confidence in B. Riley, which manages about $24 billion for clients and provides investment banking services primarily to small and medium-sized businesses.

The two B. Riley executives who served on the Franchise Group’s board were Bryant Riley, the financial company’s co-founder and co-CEO, and Kenneth Young, its president. They resigned as directors of the franchise group in March 2020, and Prophecy went bankrupt the same month. A B. Reilly spokesperson said their departures had been planned for some time. Riley had no role in the prophecy. ”

Franchise Group reported other transactions with B. Reilly during the period the two executives were directors as related party transactions, but did not report B. Reilly’s loans to Khan. Bryant Riley and Young declined to answer questions about the disclosures, according to a B. Riley spokesperson. Mr. Khan joined Franchise Group’s Board of Directors in September 2018 and became CEO of Franchise Group in October 2019.

Prophecy investors became concerned about the situation in early 2020. Lionross Capital Management, a New York investment firm, sent an analyst to figure out what Prophecy owns. In his lawsuit against Prophecy, Khan and others, Ryan Ross alleges that “Prophecy secreted a $160 million slush account from Mr. Khan and another $36 million hidden from Mr. Khan.” “We have dramatically discovered soft loans.”

Lionroth said in his complaint that Khan used more than $100 million in sub-account funds to purchase Franchise Group stock. The case was dismissed in 2022 and the parties proceeded to arbitration, but the outcome was not made public.

The final blow to Prophecy came in March 2020 when the fund’s accounting firm, Deloitte & Touche, withdrew its 2018 audit report and resigned. Prosecutors announced that Deloitte resigned after the misconduct was discovered. Representatives for Deloitte did not respond to requests for comment. Deloitte was also the Franchise Group’s auditor and continued to do so after leaving Prophecy.