How an unremarkable deal became a big threat to a small investment bank

Investors are anxious also because of B. Riley’s extensive ties to a hedge-fund manager with alleged links to a failed investment firm that prosecutors say is a fraud.
Investors are anxious also because of B. Riley’s extensive ties to a hedge-fund manager with alleged links to a failed investment firm that prosecutors say is a fraud.

Summary

B. Riley Financial is under fire for funding a buyout linked to a firm that prosecutors call a fraud.

History is littered with financial companies that were undone by one bad bet. Investors are worried that B. Riley Financial will be one of them.

B. Riley’s bet was on an unremarkable buyout of a company with an uninspiring name, Franchise Group. What made it toxic was the involvement of a hedge-fund manager who has links to a failed investment firm that prosecutors called a fraud.

Investors are anxious because B. Riley was a key funder of the deal and has extensive ties to the hedge-fund manager. New details of loans by B. Riley to the hedge-fund manager show a longer and closer relationship than previously known. 

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

B. Riley’s shares are down around 60% since August, the month the buyout closed, and it has been forced to defend its involvement. In January, the hedge-fund manager, Brian Kahn, resigned as chief executive officer of Franchise Group after a wave of news stories and social-media posts linking him to the failed investment firm.

B. Riley took a $281 million equity stake in Franchise Group, which owns Vitamin Shoppe and Sylvan Learning tutoring centers, as part of the deal. It later disclosed that it lent $201 million to Kahn’s investment firm, which pledged its Franchise Group shares as collateral. Combined, the stated value of the loan and the equity stake exceeds B. Riley’s shareholder equity.

B. Riley’s loans to Kahn date back longer than previously known. It made at least 10 different loans to Kahn and entities he controlled from 2018 through 2023, according to financing statements filed with state agencies in Nevada, Delaware and Florida, known as Uniform Commercial Code filings. The UCC filings don’t show the amounts borrowed.

Some of B. Riley’s loans to Kahn were made or in place while two B. Riley senior executives were on Franchise Group’s board, where they served from 2018 to 2020. Franchise Group didn’t disclose them as related-party transactions in its proxy statements. A possible explanation for the lack of disclosure is it may not have been required, because Franchise Group itself wasn’t a participant in the transactions.

A July 2023 slide presentation by the investment bank Nomura, which provided financing to B. Riley as part of the Franchise Group buyout, included information about B. Riley’s loans over the years to Kahn. The earliest one it listed was a $37 million loan in July 2019, and by mid-2023 the principal balance on Kahn’s loans was $154 million.

The current drama has its roots in the collapse of Prophecy Asset Management, which claimed it was overseeing almost $400 million of assets when it failed in March 2020. Prosecutors have called Prophecy a fraud that hid its trading losses. 

Kahn, as an outside adviser hired by Prophecy, managed most of its money and appears to have generated most of its 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 prosecutors. 

Hughes’s attorney declined to comment. Kahn, 50, is one of two people referred to as unnamed co-conspirators in the case, according to people familiar with the matter.

Prophecy clients in a now-resolved lawsuit alleged that Kahn secretly diverted Prophecy money to help build his controlling stake in Franchise Group. He used his stake to help take Franchise Group private in the B. Riley-financed deal last year, which valued the company at $1 billion.

Kahn declined to comment. He hasn’t been charged, and he has denied wrongdoing. In a statement last month to Bloomberg, Kahn’s lawyer, Douglas Brooks, said, “Mr. Kahn categorically denies any knowledge of wrongdoing perpetrated by the managers of Prophecy." He said that Prophecy defrauded Kahn out of tens of millions of dollars and that neither B. Riley nor Franchise Group had any dealings with Prophecy.

Referring to the Franchise Group investment, a B. Riley spokeswoman, Jo Anne McCusker, said, “We remain confident in the investment proposition and believe this will turn out to be a value-enhancing transaction for our investors." She said B. Riley has secured its rights to the shares backing its loan to Kahn and has first priority over other creditors.

Whether B. Riley does have first priority is crucial. Kahn at one point pledged his Franchise Group stock to Prophecy, according to a Securities and Exchange Commission lawsuit that referred to him as “Individual 2."

The SEC said Prophecy counted the amount—then worth almost $200 million—in its net asset value shortly before it failed. It is unclear whether Kahn pledged the same shares twice—to both Prophecy and B. Riley.

Franchise Group itself had been struggling. It reported combined net losses of $228 million during its last six quarters as a public company, mainly owing to soaring 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 mostly for small companies.

The two B. Riley executives who served on Franchise Group’s board were Bryant Riley, the financial company’s co-founder and co-CEO, and Kenneth Young, its president. They stepped down from Franchise Group’s board in March 2020, the same month Prophecy collapsed. The B. Riley spokeswoman said their departures had been previously planned and that “B. Riley had no role in Prophecy in any capacity."

Franchise Group reported other transactions with B. Riley as related-party dealings while the two executives were board members, but not B. Riley loans to Kahn. Bryant Riley and Young declined to answer questions about the disclosures, according to the B. Riley spokeswoman. Kahn joined Franchise Group’s board in September 2018 and became its CEO in October 2019.

Prophecy investors grew anxious about its situation in early 2020. LyonRoss Capital Management, a New York investment firm, sent an analyst to figure out what Prophecy owned. He “dramatically discovered Prophecy’s secret $160 million side account with Kahn and another $36 million in hidden soft loans to Kahn," LyonRoss said in a lawsuit against Prophecy, Kahn and others.

LyonRoss in its complaint said Kahn had used more than $100 million of the side-account funds to buy Franchise Group shares. The lawsuit was dismissed in 2022, and the parties went to arbitration, the outcome of which wasn’t disclosed.

The death blow to Prophecy came in March 2020 when its funds’ accounting firm, Deloitte & Touche, withdrew its audit reports for 2018 and resigned. Prosecutors said Deloitte resigned after uncovering the fraud. Deloitte representatives didn’t respond to requests for comment. Deloitte also was Franchise Group’s auditor and remained so after resigning from Prophecy.

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