(Bloomberg) — Brian Kahn, whose role in the collapse of a US hedge fund has drawn scrutiny from prosecutors and battered shares of B. Riley Financial Inc., has been accused of defaulting on parts of a settlement meant to help repay investors who lost hundreds of millions of dollars.
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The claim by a trustee overseeing the settlement is the latest twist in the failure of Prophecy Asset Management, where Kahn allegedly ran up massive losses before the fund collapsed in 2020. He is also a longstanding client of B. Riley, the Los Angeles-based investment bank, and the two have worked on multiple deals together including a buyout of Kahn’s retail company Franchise Group Inc. in August.
To compensate Prophecy’s investors, Kahn agreed to pay more than $200 million, including cash and shares in Franchise Group, according to people familiar with the matter. But Kahn has failed to pay $1.5 million in cash or turn over $5 million in shares due by a Jan. 31 deadline, according to a Feb. 13 trustee’s letter that was reviewed by Bloomberg News. He also didn’t hand over shares that he’d pledged in a separate agreement, according to the letter written by trustee Ted Gavin.
In the letter, Gavin said he contacted the American Arbitration Association to “begin the process of litigating the trust’s rights and remedies.”
The default notice adds to the pressure on Kahn and B. Riley. Their relationship has drawn attacks from short sellers that contributed to a more than 50% plunge for the firm’s shares in the past 12 months. Waves of investors betting against the stock have claimed that B. Riley’s ties to Kahn could embroil it in the Prophecy matter and impair the investment bank’s own holdings in Franchise Group.
B. Riley categorically rejects the entire premise and has lashed out at short sellers pushing the idea. In a Feb. 22 statement, the firm said that it knew nothing of Kahn’s dealings with Prophecy, it wasn’t involved with the hedge fund and that Prophecy’s demise has no impact on B. Riley’s Franchise Group holdings.
Read More: B. Riley Says Internal Review Finds No Link to Prophecy’s Demise
Kahn has consistently denied any wrongdoing and hasn’t been charged with anything. US prosecutors deemed Kahn to be an unindicted co-conspirator in a $294 million fraud case stemming from Prophecy’s collapse, Bloomberg has reported. Prophecy co-founder John Hughes pleaded guilty Nov. 2 to his own role in the matter.
The following month, prosecutors asked a federal judge to halt a lawsuit by the US Securities and Exchange Commission against Hughes that implicated Kahn in Prophecy’s troubles, saying it needed to maintain “the integrity of the criminal case and ongoing investigation,” according to a court filing.
Kahn’s Stance
A spokesman for the US Attorney’s Office in New Jersey, which is leading the criminal investigation into the Prophecy matter, declined to comment. Gavin, the settlement’s trustee and a partner at financial advisory firm Gavin/Solmonese, also declined to comment. Kahn and his attorney, Douglas Brooks, didn’t respond to messages about the default claim. In a statement last month, Brooks said Kahn was a victim of the fraud at Prophecy, not a perpetrator.
“Mr. Kahn categorically denies any knowledge of wrongdoing perpetrated by the managers of Prophecy, an entity that he stopped dealing with several years ago and which defrauded Mr. Kahn out of tens of millions of dollars,” Brooks said.
Kahn stepped down as Franchise Group’s chief executive in January, a move his attorney has said isn’t related to any impending action by US authorities.
Read More: Prophecy Fund Co-Founder Pleads Guilty to $294 Million Fraud
Still, lawyers who aren’t involved in the case said that Kahn should be concerned about the investigation by the US Attorney’s Office in New Jersey.
“Anyone who has been referred to as an unindicted co-conspirator in an ongoing investigation has ample reason to worry about forthcoming criminal charges,” said Paul Pelletier, a former federal prosecutor.
The SEC also has investigated Kahn’s interactions with B. Riley, carrying out interviews about the use of his assets to help B. Riley obtain a bank loan, Bloomberg previously reported in January. No charges have been filed by the SEC, and the regulators ultimately may take no legal action.
Kahn has worked for the past decade on various business deals with B. Riley, which specializes in advising smaller companies, sometimes taking stakes in the firms. One of them was Franchise Group, a publicly traded collection of retail chains that B. Riley helped Kahn assemble in 2019. It grew in part by acquiring retailers such as the Vitamin Shoppe and Sylvan Learning Center.
Last August, Kahn took Franchise Group private with backing from B. Riley, which acquired a 31% stake and arranged a $600 million loan to fund the venture from Nomura Holdings Inc. Among the assets that B. Riley pledged as collateral was a loan it had made to another Kahn-owned company that was secured by shares in Franchise Group.
Trading Losses
The transactions between Kahn and B. Riley have drawn scrutiny from short sellers because while he was building Franchise Group, he was also investing money for Prophecy, a hedge fund that pitched itself to clients as diverse, liquid and safe. Instead, Prophecy collapsed, with prosecutors saying Kahn did almost all the investing and the fund’s clients claiming in subsequent litigation that he put much of that money into Franchise Group.
With this in mind, investors such as veteran short seller Marc Cohodes contend that Kahn’s ownership and use of Franchise Group shares might be in jeopardy, and that this could spill over into stakes obtained by B. Riley. That’s false, B. Riley says. Kahn’s dealings at Prophecy have no impact on the investment bank’s equity ownership in Franchise Group, nor on loans where the stakes were used as collateral, according to a company statement.
Prophecy started raising funds a decade ago, telling investors it would spread their money among 30 or so “sub-advisers” who would keep a percentage of trading profits. To get the assignment, advisers had to offer cash collateral equal to about 10% of their allocation to cover any losses, and replenish the sum if their losses piled up too high.
It didn’t work that way, according to John Hughes, the Prophecy co-founder who pleaded guilty to US charges in November. According to filings by prosecutors in that case, Kahn — identified in court documents as unindicted “Co-conspirator-2” — was given most of the portfolio to invest and he sustained “massive” trading losses.
Kahn was down by $85.4 million at the end of 2018, and he couldn’t provide enough cash collateral, prosecutors alleged in filings. So Prophecy instead let Kahn put up substitutes like stocks and personal guarantees. But most of these were “fabricated and worthless,” part of Kahn’s alleged efforts along with alleged co-conspirators to forge and backdate documents to mislead auditors and investors, prosecutors said.
Around the same time, a fund run by LyonRoss Capital Management became deeply concerned about its investment in Prophecy and the hedge fund’s dealings with Kahn, and started asking questions. The firm sent an analyst to visit Prophecy’s management in January 2020 and he discovered the truth, according to a lawsuit that LyonRoss subsequently filed against Prophecy, Kahn and others.
LyonRoss Settlement
The analyst challenged Prophecy’s entire investment premise, LyonRoss said. The fund wasn’t diverse and liquid, Kahn controlled the majority of the assets including about $140 million of Franchise Group shares, and Prophecy was in shaky financial condition, the complaint claimed.
The lawsuit went to arbitration and was later dismissed, court filings show. Kahn agreed to an arbitration judgment of about $70 million, said one of the people familiar with the matter, who weren’t authorized to speak publicly.
On March 18, 2020, Prophecy’s auditor, Deloitte & Touche, resigned and withdrew its opinion for the firm’s 2018 financial statements. Prophecy was done.
None of this impairs B. Riley’s investments and loans tied to Franchise Group, the company has maintained, and it dismissed contentions by short sellers that its grip on those assets might face challenges from investors who lost money in Prophecy’s collapse.
“B. Riley has a perfected first lien security interest in the FRG equity interests collateralizing its loan,” the company said, referring to Franchise Group by its old ticker symbol. “No claim has been asserted against B. Riley for the FRG equity interests pledged as collateral for this reason,” the company said.
–With assistance from Tom Schoenberg and Jill R. Shah.
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