ACCOUNTING 250B

SPRING 1998

REVISED Copy of SUB-GROUP ASSIGNMENT

Chester Green, age 57, has been President of the Rainbow Investment Corporation ("Rainbow") since its inception in 1994. Rainbow was formed to invest the Green family fortune after the family-owned corporation, Green Corporation, was sold to a Fortune 500 company. Rainbow’s average annual return on investment was 20%.

Chester resides in Spears, PA, a town with approximately 20,000 residents. His family lived in the region for generations. While his grandfather worked in a lumberyard, his parents started a chocolate factory that eventually employed hundreds and was the center of the town’s economy. As the business grew, the Greens opened a restaurant on the main street and eventually opened 50 other restaurants throughout the state.

When his father died in 1986, Chester’s mother decided to retire from the business. Chester, a graduate of the Wharton School of the University of Pennsylvania, became president of Green Corporation in charge of the daily operations. His sister, a schoolteacher, became the corporate secretary so she could have an overview of the business without getting involved in the daily operations. Under his regime, the business continued to flourish, and more restaurants were open in the adjacent states.

Chester enjoyed the success of the corporation and the prestige of being the #1 employer of Spears. He joined the most exclusive social clubs in the area and exhibited his good fortune with his cars and other manifestations of wealth. He would brag to his friends about all the money he made from the family business as well as from the stock market. He had a way of making everything he touched turn to gold.

Green Corporation had been approached several times by large corporations to sell its operations. Chester’s mother, the majority shareholder, was not interested in selling the company and wanted to keep it in the family as long as she was alive. However, everyone has a price, and hers was met. The company was sold for $10,000,000.

The funds were under the financial management of Rainbow, with Chester in charge. All investment trades were executed through the CFG Brokerage, a non-related entity. Chester also managed to persuade some of his other friends to let him handle their investments by telling them "at the end of every rainbow, there is a pot of gold." Through his business connections, he eventually was handling $3 billion of investments for schools and other public agencies in Pennsylvania and surrounding states.

It was only a matter of time before the Spears school board decided to invest with Rainbow. They informed Rainbow that the money received from bonds that were issued for the new school needed to be invested with the expectation that it would yield a return in excess of the bond interest payments. During his presentation, Chester showed the board members charts of his proposed investment portfolio as well as the returns he could achieve. The board decided to invest the $21 million it borrowed to finance the construction of a new school complex, and an additional $5 million set aside for operations and other needs. They felt a successful local businessman would be more understanding of their needs than representatives of the large investment advisor companies who intimidated them.

During the first year, Chester attended the monthly school board meetings. He provided them with reports showing the school district’s investment portfolio was earning a return of 22%. The portfolio principal investments were in securities in which the earnings were derived from a U.S. government bonds in relation to the Japanese yen and the LIBOR. Since the interest rates were increasing, their returns were greater than expected. The board was elated with their returns with such a safe investment as government bonds.

Chester was still a powerful force within the town. So when he found his own investments decreasing, he took whatever steps he felt necessary to keep his credibility. When Rainbow began to lose money, Chester advised its investors to place their investments into one large pool with the understanding that it would produce even bigger gains. He felt the pool would allow him to hide the true value of an individual school district’s investment.

In early 1997, he decided to protect himself by having the school board agree to future investments. He proposed to the boards a derivative, with a market value of $14 million. However, he valued the investment at $83 million by adding together all the future income the security could produce. The school board saw a return of 500% and agreed to the investment.

In September 1997, another school board confronted Rainbow when a new school superintendent found discrepancies in the district’s monthly account statements. The superintendent could not reconcile the monthly statements received from CFG Brokerage to the monthly reports he had been receiving from Rainbow.

In December1997, the Securities and Exchange Commission shut down Rainbow. It charge Chester with fraud, stating that he lost over $70 million in trading high-risk bonds and then hid the losses by the investments of new clients. Chester said his intentions were good as he devoted his career helping school districts.

 ASSIGNMENT

Prepare a report that considers the following issues plus any others you think need to be addressed ( 4 pages of text maximum plus supporting items). The report should be of professional quality.The report should be addressed to a new school board member who has little knowledge of accounting or finance.