Sykes letter to IN: Closure of GunnAllen was a surprise

The following is a letter from John Sykes, the largest single shareholder in defunct broker-dealer GunnAllen Financial, in response to this question posed by InvestmentNews senior editor Bruce Kelly late last month: “What happened at GunnAllen?”

What happened at GunnAllen on Monday, March 22, 2010, did not just happen in the past day or weeks. It goes back six (6), perhaps seven (7) years when GunnAllen was experiencing rapid growth and had a need for additional capital in order to finance its growth. It was necessary for the Company to raise capital through Notes and Preferred Stock instruments and by a sale and lease back of its Corporate Headquarters. These created a tremendous debt burden and the continuing need for additional capital. The Company, in addition to its debt, was dragged into the Bluestein Ponzi scheme, several years ago, along with others investors. The Bluestein matter along with other claims by clients from older offerings and the results of hiring brokers with less than stellar backgrounds increased the Company’s need for capital to meet its legal obligations and ultimately its net capital requirements.

In the spring of 2008, due to legal claims, specifically the Bluestein matter, the need for additional capital became acute. This was compounded by the Company’s decision to become self clearing and the high cost of attempting to meet that objective. Management again looked outside for funds. In mid 2008, I was approached to consider a possible investment in the Company. I, along with others, decided to investigate the possibility of such an investment. After considering the state of the Company and considering its operating costs and the legal cost for the claims, specifically the Bluestein matter, our due diligence indicated there was a possibility for the Company to turn around. In order to accomplish this, it would be necessary to make GunnAllen lean and mean , improve the quality of its broker recruiting process and to reduce its costs as well as increase the cash flow within the Company. An estimate had to be made as to the potential exposure of the Bluestein matter, and we projected that, along with other needs, indicated a total investment need of $10M.

The precarious situation of the Company accelerated closing earlier than we would have desired. Had it not closed when it did, the Company in November 2008 would have faced the same circumstance it apparently faced on March 22, 2010. The Company hired Gordon Loetz, one member of the investor group andan experienced broker and financial advisor having owned his own Broker-Dealer with approximately 400 brokers, to be its Chairman and CEO. Gordon immediately set out to reduce expenses and within a very short period, had reduced annual operating expense by approximately $12.5M. However, shortly after the closing, certain items not known to our investment group became apparent. Amongst other items, the Company was being fired by its clearing firm. It presented an operational mess and we immediately had to direct well over $1M in basically designing, while still operating, a new operating system and subsequently another approximately $1M to implement the new system. This placed a tremendous burden upon the broker network, but they stuck with us.

Claims from the past continued to accelerate beyond that which was anticipated and it was necessary for the investor group to make our first additional investment of capital of approximately $1.8M (beyond the initial $10M) to meet the capital needs of the Company. In addition, in September of 2009, the Company negotiated a purchase of Pointe Capital, which was intended to increase the revenues and through synergies, to improve the bottom line of the Company. In order the make the acquisition, I personally loaned the Company $1.2M to buy Pointe Capital. In addition to the $1.2M, a $3M debt of Pointe Capital, came with the acquisition.

By October, 2009, the litigation matters had increased to approximately $56M in gross claims. Even though those would probably be settled for something less, even at $.10 on the dollar, it would be $5.6M to make settlements, if they could be made at $.10 on the dollar. That did not include the legal expense necessary to handle the claims. In less than one year, the investor group had invested an approximate total of $13M in the Company, up to $11M of which went to legal expense and settlement of past claims. It became obvious that the necessary capital to continue operating the Company would continue to go for legal claims of arbitrations arising out of pre-2009 client matters and it just did not make sense for our investment group to have $.85 of every invested dollar go to the settlement of legal claims and legal expense, as it would not allow any funds to grow the Company to create a return for its investors.

At that point, the investment group decided not to make any further investments. As a result of this decision, the Board members representing the investment group felt it would be appropriate to and did resign from the Board. That left the two (2) remaining Board members who were the original founders of the Company, namely Richard Allen Frueh and Donald J Gunn.

Still, additional capital would be needed in order to meet net capital requirements of the Company, and to give it sufficient time for the transition of the Company, either to a sale, or into a wind down. To provide that amount of time, I agreed to put additional capital into the Company and to utilize the repurchase of Pointe Capital as one of the ways for doing so. It was agreed, by the then remaining two board members, that JHS Capital Holdings would repurchase Pointe Capital for $1.8M, which was higher than the price of $1.2M just months earlier. In addition, we took the subordinated debt of $3M away from the Company as well. The Company, in my opinion, has met its net capital needs through this infusion of capital.

I was informed that the Board and its advisors continued to seek solutions for the Company and sought out other investors. There were some opportunities which came in, most of which I am not privy to, with the exception of two (2): one was an asset purchase, and the other an investment opportunity to acquire a significant portion of the Company. In early February, the Company advised me of the two (2) opportunities and asked if the investor group would consider approving either of the proposals. In a letter to the Company dated February 8, 2010, we indicated we would be more favorable to the investment to acquire a significant portion of the Company, but realized timing of that may not be practical, but if it were, that would be the approach that would potentially benefit the shareholders and note holders of the Company and obtain favorable consideration from our investor group. Under either of these alternatives, there would be certain conditions or representations that we sought to protect customers and debt holders. We received no response to our letter.

It soon became evident the Company was pursuing an asset sale to Progressive Asset Management and we received a copy of a definitive agreement for such sale. In addition, JHS Capital Advisors, Inc. had submitted a letter on February 22, 2010, offering, as a back up, to purchase certain assets of the Company and would have paid a fair amount to an escrow account in favor of the Company’s claimants. Such amount would have been paid upfront, as opposed to a five (5) year installment program as proposed by Progressive. That offer was rejected by the Company.

On March 12, 2010, JHS Capital Advisors, Inc. submitted a third letter indicating the conditions upon which the investor group could approve an asset sale to Progressive and reiterating JHS Capital Advisors, Inc.’s offer to purchase certain assets which could have brought $2.2M into the escrow account for the Company’s claimants. No response was received to the March 12 letter. On Friday, March 19, 2010, at 3:00 PM, our attorneys received a call from the Company seeking to make a deal and requesting us to consider the purchase of the total Company, or at least, certain assets of the Company. The reason given for that request was the audit which had been made by the auditors for GunnAllen, as well as audit oversight by FINRA, which indicated the immediate need for $1M. It was indicated to us at that time, it would be necessary for the funds to be made available on Monday, March 22, 2010, or there was a strong possibility the Company would need to declare they did not have sufficient net capital. Needless to say, this came as a shock to us as and I’m reasonably certain, a shock to the management team at GunnAllen.