Francis Chou, manager of Toronto-based Chou Funds, has in the past not been a fan of financial stocks. During a previous rally, he warned unitholders to stay away from them because of the DROP principle (D is for dribbling out the bad news slowly, R is for raising money, and OP is for dishing out the most optimistic projections). “Once the money has been raised from investors, these companies will announce a few months later ‘the big drop’ – that is, to take a big writedown,” he wrote.

Chou is not as negative on the current rally in bank stocks. When he coined the DROP principle during a previous rally, he “was trying to alert unitholders to the dangers of toxic assets in the balance sheets of financial companies. They were not written down and the financial companies may try to raise capital before they had to declare the true extent of their losses in toxic assets ….That is not applicable now because of the cataclysmic losses they reported in 2008.”

He adds: “Banks that have not been affected by the financial crisis will do quite well in the future. With the governments driving the treasuries to yield nearly 0%, the spread between what the banks are paying for deposits and borrowings in the market (like FDIC insured), and what they can lend at is enormous. For the first time in many years, banks are being paid handsomely for the risks they are taking.”

Which banks have come through the crisis relatively unscathed? Royal Bank of Canada and other Canadian banks have. In the U.S., big banks that got through the crisis without government funds were (according to an IMF chart in this document):

JP Morgan Chase (JPM)
Wells Fargo (WFC)
US Bancorp (USB)

Even before Livent became a publicly traded company, its financial statements were “materially misstated,” as a result of a payment scheme that saw Garth Drabinsky and Myron Gottlieb channel millions of dollars into their own bank accounts, a forensic accountant testified today at the criminal fraud trial of the Livent founders.

Between 1990 and 1993, Drabinsky and Gottlieb funneled $8.1 million from two suppliers of the company as part of a scheme to improperly divert money out of Livent, said Paul Coort, a forensic accountant who has been hired by the RCMP to analyze the complex web of allegedly fraudulent financial transactions that eventually forced the company into bankruptcy in 1998.

According to reports presented in court, the scheme worked this way: Drabinsky and Gottlieb charged Kofman Engineering and Execway Construction – construction companies that helped  Livent build its impressive theatres in New York, Chicago and Toronto – for bogus business services that were never performed. The construction companies would recoup that money by submitting inflated or bogus construction invoices to Live Entertainment Corporation of Canada (LECC) – a predecessor company of Livent that was controlled by MyGar Partnership – a private company controlled equally by Drabinsky and Gottlieb.

The scheme changed in 1992 when Kofman began paying millions to King Commodity Services, a private company controlled by Gottlieb. Drabinsky and Gottlieb would then bill King Commodity Services for the same amount.

Under the scheme, Drabinsky collected $3.98 million under the scheme while Gottlieb received $4.14 million between 1990 and 1993, said Coort.

Peter Kofman, the president of Kofman Engineering, has already testified that Drabinsky, Gottlieb and King Commodity Services never performed any work for him. Kofman testified that he felt pressured to participate in the scheme because Livent was his largest client.

Of the $8.1 million paid to Drabinsky and Gottlieb, about $6.8 million wound up recorded as assets on the balance sheet of LECC, Coort said. “The payments to Kofman [and Execway] that we traced to Mr. Drabinsky and Mr. Gottlieb were being recorded as assets of MyGar,” said Coort.

“If the payments… are unrelated to construction costs and unrelated to preproduction costs, is it proper to book them to the company’s balance sheet?” asked crown prosecutor Alex Hrybinsky.

“No,” Coort replied.

“What do those transactions do to the balance sheet?” Hrybinsky asked.

“Since these items are unrelated to the assets of MyGar, they would have overstated them,” Coort said.

Those improperly recorded assets on MyGar’s books were eventually rolled into the financials of Livent when the company filed its initial public offering in early 1993, Coort said. At the time of the IPO, Livent’s total assets were about $97 million, including about $6.8 million in allegedly bogus Kofman and Execway charges.

That is more than enough to mark the charges as a “material misstatement,” according to guidelines laid out in the Canadian Institute of Chartered Accountants handbook – the Bible of Canadian accounting, Coort said.

Prosecutors have alleged that the payments were a way for Drabinsky and Gottlieb to circumvent covenants in the company’s $60 million loan agreement with the Royal Bank that restricted the amount of money the pair could withdraw for the company.

In 1991, Drabinsky and Gottlieb were limited to a total of $900,000 each plus an additional $100,000 for expenses, Coort pointed out. In 1993 the bank increased that amount to $1.2 million plus the $100,000 in expenses.

Prosecutors also took Coort through several examples of allegedly fraudulent accounting practices such as “expense rolls” and “show-to-show transfers,” and “transfer to fixed assets” utilized by Livent. Other witnesses have descried the practices in detail over the five-month long trial.

An example of a “rolled expense” can be found in 1994 when Livent cancelled more than US$500,000 in invoices from Echo Advertising – Livent’s main advertising agency – that were incurred in 1994 and “rolled” them into 1995, Coort pointed out.

Those Echo invoices have been the subject of a great deal of testimony. Echo executives testified last week that cancelling the invoices and re-issuing them in 1995 was not an unusual practice for advertising clients.

Defence lawyers have grilled other witnesses about the probity of moving the advertising expenses from 1994 to 1995. After all, the defence lawyers have argued, the advertising would likely benefit shows in 1995, and thus make it an appropriate expense for that period.

But so far, no witnesses have agreed to that proposition. Gordon Eckstein, Livent’s former senior vice president of finance and administration, argued that it is impossible to know which ad benefits which future performance and so the expenses must be taken in the period that the ad ran. Maria Messina, Livent’s former chief financial officer testified that a show would have to be completely sold out before you could book advertising expenses into future periods.

Coort had a simpler explanation for why it was wrong. The items were essentially erased from the company’s computerized accounting system. “There is no reason for a company not to record an item,” he said. “These items were removed completely. I can’t see any justification for that.”

The forensic accountant pointed prosecutors to Livent’s 1997 financial statements to illustrate examples of “show-to-show transfers,” and “transfers to fixed assets,” Coort said. In that year, $600,000 in costs associated with Show Boat in Vancouver were transferred to other Show Boat productions in Los Angeles, Cleveland, Detroit, Boston and St. Louis.

Expenses from Show Boat Vancouver were also transferred to fixed assets, Coort explained. In one instance, Coort tracked the movement of an invoice from Echo Advertising for US$31,655 in ads purchased on a Seattle television station to promote Show Boat Vancouver. That expense was removed from the Show Boat account and reclassified as a fixed asset associated with the “signage” at Oriental Theatre in Chicago.

“The question is does it make any sense that this would be transferred to the fixed asset account of a theatre in Chicago?” Coort said. “I would say not.”

The trial resumes Wednesday after defence lawyers requested a day to prepare their cross examinations of Coort. Brian Greenspan assured the court they would wrap up their questioning of the forensic accountant in one day.