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In re Brooke Corp.

United States District Court, Tenth Circuit

June 18, 2013

In re BROOKE CORPORATION, et al., Debtors
v.
KUTAK ROCK, LLP, a Nebraska Limited Liability Partnership; ROBERT D. ORR, ANITA LARSON, LELAND G. ORR, DERROL D. HUBBARD, JOE L. BARNES, JOHN L. ALLEN, SHAWN T. LOWRY, BRYAN C. WHIPPLE, CHAD S. MAXWELL, DANE DEVLIN, MITCHELL G. HOLTHUS, KYLE GARST, MICHAEL HESS; CHRISTOPHER J. REDMOND, Trustee of Brooke Corporation, Brooke Capital Corporation and Brooke Investments, Inc., Plaintiff, and SANDLER O’NEILL & PARTNERS, L.P., a Delaware limited partnership, MACQUARIE HOLDINGS USA INC., a Delaware corporation, and OPPENHEIMER & CO. Inc., a New York corporation, Defendants. Adv. No. 10-06246-DLS

John J. Cruciani Douglas J. Schmidt #70002 Benjamin F. Mann #70047 John J. Cruciani #16883 Michael D. Fielding #20562 Michael E. Norton #17508 Husch Blackwell LLP Attorneys for Trustee

SECOND AMENDED COMPLAINT

COMES NOW, Plaintiff, Christopher J. Redmond, Chapter 7 Trustee of Brooke Corporation, Brooke Capital Corporation, and Brooke Investments, Inc. (collectively “Debtors”), in his capacity as Trustee and on behalf of Debtors’ general unsecured creditors, and for his Second Amended Complaint, which only amends Count XIII (Count XIV in the First Amended Complaint) against Sandler O’Neill & Partners, L.P., Macquerie Holdings (USA) Inc., and Oppenheimer & Co. Inc., eliminates Count XIII of the First Amended Complaint, and corrects the name of the Trustee in paragraph 1, states and alleges as follows:

Parties

1. Plaintiff Christopher J. Redmond (“Trustee”) is the Chapter 7 Trustee of Brooke Corporation (“Brooke Corp.”), Brooke Capital Corporation (“Brooke Capital”), and Brooke Investments, Inc. (“Brooke Investments”) (Brooke Corp. and Brooke Capital hereinafter collectively referred to as “Brooke”).

2. Defendant Kutak Rock, LLP (“Kutak”) is a Nebraska limited liability partnership doing business in Kansas as a foreign limited liability partnership. It may be served through its registered agent, David A. Jacobson, 1650 Farnam Street, Omaha, Nebraska 68102.

3. Defendant Robert D. Orr is a Kansas resident. He is the founder and former CEO of Brooke Corp. and was Chairman of the Brooke Corp. Board of Directors from 1991-2008.[1]

4. Defendant Leland Orr is a Kansas resident and a former CEO of Brooke Corp. Leland Orr served on Brooke Corp.’s Board of Directors from 1996-2008, and was a member of the Audit Committee from 2001 until April 2004, when he was replaced by Joe Barnes. Leland Orr also served on Brooke Franchise Corporation’s (later Brooke Capital) Board of Directors from April 2006 through June 2007.

5. Defendant Anita Larson is a Kansas resident and served on Brooke Corp.’s Board of Directors from January 2005 through July 18, 2007.

6. Defendant Michael Hess is a Kansas resident and served on Brooke Corp.’s Board of Directors from 2004 through January 2005.

7. Defendant Derrol Hubbard is a New Mexico resident and served on Brooke Corp.’s Board of Directors from January 2001 through March 2008. Hubbard was also a member of the Audit Committee from 2003 until 2008.

8. Defendant John Allen is a Kansas resident and served on Brooke Corp.’s Board of Directors from January 2001 through 2008. Allen was also a member of the Audit Committee from 2003 until 2008.

9. Defendant Joe Barnes is a Kansas resident and served on Brooke Corp.’s Board of Directors from April 2003 through 2008. Barnes was also a member of the Audit Committee from 2003 until 2008.

10. Defendant Shawn T. Lowry is a Kansas resident and served on Brooke Corp.’s Board of Directors from April 2006 through May 2007. Lowry also served on Brooke Franchise Corporation’s (later Brooke Capital) Board of Directors from 2004 through May 2007.

11. Defendant Mitchell G. Holthus is a Kansas resident and served on Brooke Corp.’s Board of Directors from April 2006 through 2008. Holthus also served on Brooke Franchise Corporation’s (later Brooke Capital) Board of Directors from 2003 through 2006.

12. Defendant Kyle Garst is a Kansas resident and served on Brooke Corp.’s Board of Directors from May 2007 through August 2007. Garst also served on Brooke Franchise Corporation’s (later Brooke Capital) Board of Directors from 2004 through 2008.

13. Defendant Bryan C. Whipple is a Kansas resident and served on Brooke Franchise Corporation’s (later Brooke Capital) Board of Directors from April 2006 through 2007.

14. Defendant Chad S. Maxwell is a Kansas resident and served on Brooke Franchise Corporation’s (later Brooke Capital) Board of Directors during 2007.

15. Defendant Dane Devlin is a Kansas resident and served on Brooke Franchise Corporation’s (later Brooke Capital) Board of Directors from 2004 through 2008.

16. Defendant Sandler O’Neill & Partners, L.P. is a Delaware limited partnership. It may be served through its registered agent, The Prentice Corporation System, Inc., 2711 Centerville Road, Suite 400, Wilmington, Delaware 19808.

17. Defendant Macquarie Holdings (USA) Inc. is a Delaware corporation. It may be served through its registered agent, The Corporation Trust Company, Corporation Trust Center, 1209 Orange Street, Wilmington, Delaware 19801.

18. Upon information and belief, Macquarie Holdings (USA) Inc. is the successor to Fox-Pitt Kelton Cochran Caronia Waller LLC (“Fox-Pitt Kelton”).

19. Defendant Oppenheimer & Co. Inc. (“Oppenheimer”) is a New York corporation. It can be served through its registered agent, Corporation Service Company, 80 State Street, Albany, New York 12207.

Jurisdiction

20. This Court has jurisdiction over this matter pursuant to 28 U.S.C. §§ 157 and 1334 and 11 U.S.C. § 328.

21. Venue lies properly in this Court, pursuant to 28 U.S.C. §§ 1408 and 1409.

Facts Common To All Counts

I. Debtors’ Bankruptcy Filings

22. Brooke Corp. and Brooke Capital filed voluntary Chapter 11 petitions on October 28, 2008 in the United States Bankruptcy Court for the District of Kansas.

23. Brooke Investments filed a voluntary Chapter 11 petition on November 3, 2008, in the United States Bankruptcy Court for the District of Kansas.

24. On June 29, 2009, this Court entered an Order converting the Chapter 11 proceedings to Chapter 7 proceedings.

25. This Court has entered orders directing the joint administration of the Debtors’ three cases.

26. As the representative of the bankruptcy estates, the Trustee is authorized to pursue all causes of action that belong to the estates as well as any applicable state law avoidance actions pursuant to 11 U.S.C. §§ 323(b) and 544(b). The Trustee is also authorized to pursue causes of action on behalf of Debtors’ general unsecured creditors.

II. The Nature and Structure of the Debtors’ Businesses

27. Brooke Corp. was a Kansas corporation headquartered in Kansas. Brooke Corp. was a publicly traded company. Brooke Corp. was a holding company listed on the NASDAQ Global Market under the symbol “BXXX”. Among other interests, Brooke Corp. owns 81 percent of Brooke Capital. The majority of Brooke Corp.’s stock was owned by Brooke Holding Inc. (“BHI”) which, in turn, was owned by the Orr family.

28. Brooke Capital (formerly Brooke Franchise Corporation) is a Kansas corporation headquartered in Kansas. Brooke Capital was also a publicly-traded company that was listed on the American Stock Exchange under the symbol “BCP.” Brooke Capital was an insurance agency and finance company that distributed insurance services through a network of franchisee and company-owned locations. At its peak in 2007-08, Brooke had over 900 franchise locations.

29. Brooke Capital owns 100% of the stock of Brooke Investments. Brooke Investments is a Kansas corporation headquartered in Kansas.

30. Aleritas Capital Corp. (“Aleritas, ” formerly Brooke Credit Corp.) is a Delaware corporation headquartered in Kansas. Aleritas was primarily engaged in the business of lending to Brooke franchisees and other insurance agents.

31. The Debtors, and approximately thirty other affiliated companies, were engaged primarily in the business of selling insurance and related services through franchisees.

32. Prior to 2001, most of Brooke’s revenues were derived from sales commissions on the sale of property and casualty insurance policies through its franchisees, and consulting, lending and brokerage services provided to franchisees, funeral homes and Allstate insurance agencies.

33. Brooke created new franchises in two ways: (1) converting an existing agency (“conversion franchise”), or (2) starting a new franchise (“SUP”).

34. In a typical conversion transaction, Brooke would identify a prospective independent insurance agency it hoped to convert into a Brooke franchise location.

35. Brooke would then assist the seller to prepare the agency for sale and, at the same time, recruit prospective franchisees to purchase the agency.

36. Once Brooke identified an interested buyer, Brooke and the buyer would enter into a franchise agreement and purchase agreement for the acquisition of the agency.

37. In 2004, Brooke initiated its SUP franchise program.

38. In a SUP transaction, Brooke would identify a prospective franchise location, and then assist the franchisee in opening the new location.

39. Regardless of whether the franchisee obtained its franchise as a conversion franchise or a SUP franchise, every franchisee would enter into a franchise agreement with Brooke.

40. Pursuant to the franchise agreements, franchisees agreed to pay Brooke franchise fees (including an Initial Franchise Fee for Basic Services (“Initial Franchise Fee”) and Buyer Assistance Plan Fees (“BAP Fees”) for other acquisition-related fees), and to share a percentage of their sales commissions with Brooke going forward.

41. Both the costs associated with the acquisition of the agency and the franchise fees would typically be financed through Brooke’s lending subsidiary, Aleritas.

42. In return for payment of the Initial Franchise Fee and a share of the sales commission revenue, Brooke agreed to provide ongoing franchisor services throughout the life of the franchise relationship in accordance with the franchise program developed by Brooke, including:

(a) Training of all franchisees at Brooke’s training academy;
(b) The use of Brooke’s registered trade names;
(c) Establishing and maintaining contractual relationships with insurance carriers so that the franchisees had companies through which they could place coverage;
(d) Advertising services, including traditional advertising, direct mail advertising, yellow pages advertising, public relations, lead generation, and office location analysis, developing marketing programs, coordinating advertising purchases, and conducting local, regional, and national advertising programs;
(e) An internet based document management system, including the storage and maintenance of records for the franchisee in an electronic database, and providing each franchisee with access to the electronic records related to the respective franchisee via the internet;
(f) Assisting franchisees in obtaining and maintaining their insurance licenses;
(g) Cash management services, including the billing and collection of insurance premiums, remitting premiums to the respective carriers, the receipt and allocation of commission revenues, the receipt and processing of agency related bills (including bills related to rent, utilities, advertising, service providers, etc.), the establishment and maintenance of trust accounts for the receipt and processing of premium and commission payments, and the provision of a monthly franchise statement reconciling all of the financial transactions affecting the franchisee’s location each month; and
(h) Ongoing franchisee support through the national processing center (collectively referred to as “Franchisor Services”).

III. Brooke’s Unsustainable Business Model

43. Brooke Corp. operated primarily through its operating subsidiaries: Aleritas and Brooke Capital.

44. During the first ten years of its existence, Brooke primarily sold administrative services to bank-owned insurance agencies.

45. In 1996, Brooke established a franchise model for expansion and developed a lending program to facilitate acquisition of existing insurance agencies by Brooke franchisees.

46. From 1996 to 2000, Brooke’s revenues consisted almost entirely of a percentage of commissions earned by its franchisees, which Brooke retained in exchange for administrative services provided to the franchisees.

47. In 2001, however, Brooke began to restructure its operations and create additional sources of revenue. Specifically, it:

(a) began charging BAP Fees to prospective franchisees in conjunction with the franchisee’s acquisition of a franchise; and
(b) began realizing gains on the sale of loans it had initiated and sold to participating banks.

48. Starting in the fourth quarter of 2003, Brooke began, for the first time, charging its franchisees a significant Initial Franchise Fee for Franchisor Services in addition to the BAP Fees.

49. Through the end of 2003, all Brooke franchises were conversion agencies, meaning that the franchisee owned or acquired an existing agency when it signed up to become a Brooke franchisee.

50. Prior to 2003, Aleritas employed a business model whereby it would fund loans by selling participation interests in individual loans to a network of local banks. In 2003, however, Aleritas started using loan securitizations as well as loan participations. Loan securitizations involve a finance process that distributes risk by aggregating assets into a pool and issuing new securities backed by those assets and their cash flows. The securities were then sold to investors.

51. By the end of 2007, approximately 45% of the total loans Aleritas had initiated had been securitized into one of seven securitizations. Aleritas was required to over-collateralize the securitizations, which meant Aleritas had to absorb the first 15-25% of losses in any given securitization before investors would lose any of their interest in the remaining percentage of the loan.

52. Of the remaining unsecuritized loans that had been initiated by Aleritas, 35% had been sold without recourse to participating banks. The remaining 20% remained unsold and on Aleritas’s books.

53. Notwithstanding Aleritas’s apparent minimal exposure to the loans it had initiated, both Brooke and Aleritas were under tremendous pressure for all the loans to perform because their business model depended on a continuous stream of willing buyers for the loans.

54. Between 2004 and 2007, Brooke experienced tremendous growth in the number of franchises. The apparent success of a significant number of those franchises was, however, illusory.

55. As noted earlier, Brooke began a program of start-up agencies in 2004. In a SUP transaction, the franchisee was recruited and setup in a new franchise without the benefit of existing business. Again, almost all of the costs for SUPs were financed through loans provided by Aleritas.

56. In many instances, the commission revenues of Brooke franchisees in both conversion and SUP locations were not adequate to cover the franchisee’s loan payments or other expenses. Brooke absorbed the shortfalls and advanced funds to the franchisee to cover them.

57. The success rate for SUPs was abysmal. As of September, 2008, less than one-third of SUPs were able to timely meet their payment obligations.

58. To keep pace with its rapid growth, Brooke’s payroll costs increased very quickly to support, manage and control the rapidly growing franchise network. Its other operating expenses increased even more dramatically, reflecting the cost of continued subsidization of an ever-growing portfolio of troubled franchises.

59. Brooke was hemorrhaging excessive amounts of money as it subsidized the various expenses (including loan repayments) of underperforming franchises. By 2007, these expenses had grown so dramatically that, even with an increase of 144 franchises that year, the Initial Franchise Fees were no longer sufficient to cover Brooke’s other operating expenses.

IV. Brooke’s General Corporate Governance and Audit Committee

60. Brooke Corp. was governed by a Board of Directors.

61. The Brooke Corp. Board of Directors had three committees: the Executive Committee, the Compensation Committee, and the Audit Committee. The Audit Committee was formed in 2001.

62. From 2001 until April 2004, the Audit Committee had three members: Leland Orr, Derrol Hubbard, and John Allen.

63. The Audit Committee’s primary responsibilities were to assist the Brooke Corp. Board of Directors in fulfilling its oversight responsibility to the shareholders relating to the integrity of Brooke’s financial statements, to ensure Brooke’s compliance with legal and regulatory requirements, and to ensure the qualifications, independence, and performance of Brooke’s independent auditor.

64. As it relates to the independent auditor, the Audit Committee was responsible for the appointment, compensation, retention and oversight of the work of the independent auditor engaged for the purpose of preparing or issuing an audit report or performing other audit, review or attestation services for Brooke.

(a) The Audit Committee’s Decision Not to Designate a Financial Expert

65. Prior to 2004, the Audit Committee had not designated a “financial expert” member of the Audit Committee, because Brooke claimed that, as a small business filer, it was not required to have a “financial expert” on the Audit Committee.

66. In 2004, Brooke lost its small business filer exemption under AMEX.

67. As a result of the loss of its small business filer exemption, Brooke informed the Brooke Corp. Board of Directors that it was required to have an Audit Committee that consisted entirely of independent committee members, and was required to either (1) have a financial expert among its members, or (2) disclose in its public filings that it had not appointed a financial expert to serve on the Audit Committee.

68. In correspondence dated January 10, 2004, Robert Orr expressed his reluctance to have a financial expert on the Audit Committee, and asked Brooke’s in-house counsel to confirm that Brooke was required to have a financial expert on the Audit Committee.

69. The requirement to have a financial expert on the Audit Committee was confirmed by Brooke’s in-house counsel, Anita Larson, on January 10, 2004.

70. In an e-mail dated January 15, 2004, Larson reversed her earlier opinion that the Audit Committee was required to have a financial expert. Larson informed Robert Orr that Brooke was not required to have a financial expert on the Audit Committee so long as (1) Brooke disclosed in its public filings that it did not have a financial expert on the Audit Committee, and (2) the collective knowledge of the Audit Committee members satisfied the “various aspects of the definition of financial expert.”

71. Larson described the attributes of a financial expert to include an understanding of GAAP and financial statements; an ability to assess the general application of GAAP in connection with accounting for estimates, accruals, and reserves; experience preparing, auditing, analyzing, or evaluating financial statements that present a breadth and level of complexity of accounting issues that are generally comparable to the breadth and complexity of issues that can be expected to come up with the company; an understanding of internal controls and procedures for financial reporting; and an understanding of Audit Committee functions.

72. In an e-mail dated January 19, 2004, Robert Orr expressed his desire to delay, for as long as possible, the removal of his brother, Leland Orr, from the Audit Committee and the appointment of a third independent Audit Committee member.

73. In a Memorandum to the Brooke Corp. Board of Directors dated January 20, 2004, Robert Orr recognized the requirement that the Audit Committee consist entirely of independent board members. Orr explained that, in anticipation of this requirement, Joe Barnes was elected to the Brooke Corp. Board of Directors in 2003, and after the directors were elected at the next stockholder meeting, all three of the independent directors must serve on the Audit Committee.

74. In the same Memorandum, Robert Orr also recognized that “the revised rules require that all independent board members on the Audit Committee be able to read and understand fundamental financial statements and that one independent board member of the Audit Committee be certified as financially sophisticated.”

75. Barnes was a physician practicing in Smith County, Kansas. Barnes had no previous education or employment in the financial or accounting industry and did not satisfy any of the standards of a “financial expert.”

76. Orr went on to explain that AMEX’s requirement that the Audit Committee have a financial expert was waived if the lack of a financially sophisticated independent committee member was disclosed in the annual proxy statement.

77. In an e-mail dated January 22, 2004, one of Brooke’s in-house attorneys advised Robert Orr and Anita Larson that both AMEX and Sarbanes Oxley required that Audit Committee chairs be “financially sophisticated” and Audit Committee members be “financially literate.”

78. In advance of Brooke Corp.’s annual meeting, Robert Orr proposed to Brooke Corp.’s Board of Directors that it not certify any Audit Committee member as financially sophisticated, but instead, disclose that it did not have a financially sophisticated independent board member serving on its Audit Committee.

79. Orr also suggested that Brooke Corp.’s Board of Directors allocate funds to the Audit Committee for the purpose of “retaining an outside consultant to assist, educate, and advise the Audit Committee.”

80. On February 2, 2004, Brooke Corp. held its regular meeting of the Board of Directors. All members of the Brooke Corp. Board of Directors attended the meeting.

81. At the meeting, the Brooke Corp. Board of Directors discussed the issue of whether to have a financial expert on the Audit Committee.

82. Robert Orr again suggested to the Brooke Corp. Board of Directors that instead of naming a financial expert to serve on the Audit Committee, the Audit Committee should just be given authority to retain outside financial consultants, including the retention of an independent, qualified, financial expert consultant, to assist it in fulfilling its duties.

83. Robert Orr asked the Brooke Corp. Board of Directors to consider retaining such a financial expert consultant to assist the Audit Committee and stated that Brooke would ensure that the Audit Committee had funds to pay for financial expert consulting services.

84. Brooke Corp.’s Board of Directors did not designate a financial expert on the Audit Committee.

85. Instead of appointing a financial expert to serve on the Audit Committee, Brooke Corp.’s Board of Directors opted to disclose that it did not have a financial expert serving on its Audit Committee. The disclosure, contained in Brooke’s SEC filings, stated:

The members of the Audit Committee have owned and/or have participated in the management of businesses. The Audit Committee members’ combined financial acumen is strong, and therefore, an Audit Committee financial expert is not necessary for a proficient discharge of all Audit Committee responsibilities to the Company’s Board of Directors and Shareholders. Specifically, the Board believes that the current members of the Audit Committee as a group have an understanding of audit committee functions, have the ability to understand financial statements and generally accepted accounting principles, have substantial business experience that results in financial sophistication, have the ability to assess the general application of such principles in connection with the accounting for estimates, accruals and reserves and have an understanding of internal controls and procedures for financial reporting. In addition, the Committee’s Charter grants the Audit Committee authority to retain advisors with financial expertise at the Company’s expense. The Company’s controlling shareholder and the Company’s Board of Directors have encouraged the Audit Committee to retain such advisors that the Audit Committee, in its sole discretion, feels that such expertise is needed, or desired, and have encouraged the selection of advisors who met the independence standards applicable to independent directors.

86. Along with the Brooke Corp. Board of Directors, Kutak also knew that there was not a “financial expert” on the Audit Committee.

87. Kutak was retained as Brooke’s legal counsel as early as 2004 to provide broad and wide ranging legal advice regarding issues such as corporate governance, compliance with applicable securities laws and regulations, SEC reporting requirements, securitization issues, and other legal issues related to the overall operation of Brooke’s business.

88. On or around March 16 through March 18, 2005, Kutak performed a due diligence review of Brooke in connection with a proposed public offering of Brooke common stock.

89. As part of the due diligence review, Kutak reviewed Brooke “documents used or received by [Brooke] for purposes of determining whether directors . . . qualify as ‘financial experts’ for Audit Committee purposes . . . .”

90. Moreover, Kutak drafted, edited, and reviewed a Form S-1 Registration Statement filed by Brooke with the SEC on April 21, 2005, in connection with the public offering (“2005 S-1”), which stated:

Our board of directors has determined that none of its members qualifies as an audit committee financial expert as defined by applicable Securities and Exchange Commission regulations. The reason that our board of directors has not appointed an audit committee financial expert is because we believe that the current members of our audit committee as a group have an understanding of audit committee functions, have the ability to understand financial statements and generally accepted accounting principles, have substantial business experience that results in financial sophistication, have the ability to assess the general application of such principles in connection with the accounting for estimates, accruals and reserves and have an understanding of internal controls and procedures for financial reporting. Our audit committee’s charter grants the audit committee authority to retain advisors with financial expertise at our expense. Our controlling shareholder and board of directors have encouraged our audit committee to retain such advisors if our audit committee, in its sole discretion, believes that such expertise is needed, or desired, and have encouraged the selection of advisors who meet the independence standards applicable to independent directors.

91. Nevertheless, Kutak failed to advise Brooke Corp.’s Board of Directors of the legal risks associated with not having a “financial expert” on the Audit Committee.

(b) The Brooke Corp. Board of Directors’ Failure to Make An Informed Decision Regarding the Competence of Brooke’s External Auditors and the Accuracy of Brooke’s Financial Statements

92. On March 20, 2004, Robert Orr wrote a memo to the Audit Committee. In that memo, Orr recognized internal shortcomings in the accounting department and acknowledged that the accounting department must improve in certain areas and that additional qualified accounting personnel were required to make those improvements.

93. On March 22, 2004, a telephonic meeting of the Audit Committee was held. At that meeting, the Audit Committee members discussed the use of Summer, Spencer & Callison, CPA’s Chartered (“SSC”) as Brooke’s external auditors. Mr. Allen asked if it mattered if the Company used a “big name firm” to perform its audit and the potential impact on investor confidence. Leland Orr noted that this was a potential concern, and that in the future, Brooke may want to consider retaining a big name firm.

94. A “big name firm” was never retained, nor was it ever addressed again by the Audit Committee.

95. Furthermore, the Audit Committee did not perform any due diligence prior to retaining SSC to serve as Brooke’s external auditor for 2004 or do anything else to determine whether SSC had any experience auditing publically traded companies or franchisors.

96. In early April 2004, Brooke filed its preliminary proxy statement and notice of 2004 annual meeting to be held on April 22, 2004.

97. Among the issues to be voted on at the annual meeting were (1) the election of six directors to the Brooke Corp. Board of Directors, and (2) the selection of SSC to serve as Brooke’s independent auditor for the fiscal year ending December 31, 2004.

98. The preliminary proxy described certain corporate governance and board matters, including changes to the Audit Committee.

99. The Preliminary Proxy stated:

During 2003, the Audit Committee was comprised of three members: John Allen, Derrol Hubbard, and Leland Orr. John Allen and Derrol Hubbard are independent, as that term is defined by the American Stock Exchange LLC; therefore, the Audit Committee composition was compliant with the requirements applicable to small business filers. However, at the Board of Directors’ Annual Meeting, the composition of the Audit Committee will change in that, if all nominees are elected, it will become entirely comprised of independent directors.
The Company has not designated an “audit committee financial expert.” All members of the Audit Committee have owned and/or have participated in the management of businesses. The audit Committee members’ combined financial acumen is strong, and therefore, an Audit Committee financial expert is not necessary for a proficient discharge of all Audit Committee responsibilities to the Company’s Board of Directors and shareholders. Specifically, the Board believes that the current members of the Audit Committee as a group have an understanding of Audit Committee functions, have the ability to understand financial statements and generally accepted accounting principles, have substantial business experience that results in financial sophistication, have the ability to assess the general application of such principles in connection with the accounting for estimates, accruals and reserves and have an understanding of internal controls and procedures for financial reporting. In addition, the Committee’s Charter grants the Audit Committee authority to retain advisors with financial expertise at the Company’s expense. The Company’s controlling shareholder and the Company’s Board of Directors have encouraged the Audit Committee to retain such advisors if the Audit Committee, in its sole discretion, feels that such expertise is needed, or desired, and have encouraged the selection of advisors who meet the independence standards applicable to independent directors.

100. Brooke’s 2004 annual meeting was held on April 26, 2004.

101. On the recommendation of Brooke Corp.’s Board of Directors, SSC was selected to serve as Brooke’s independent auditor for the fiscal year ending December 31, 2004, and Robert Orr, Leland Orr, Michael Hess, Derrol Hubbard, John Allen, and Joe Barnes were elected to serve on Brooke Corp.’s Board of Directors.

102. Likewise, Brooke Capital's Board of Directors selected SSC to serve as Brooke Capital's external auditors.

103. At the annual meeting in 2004, Brooke Corp.’s Board of Directors amended the Charter of the Audit Committee of the Board of Directors of Brooke Corp.

104. Pursuant to the Amended Charter Agreement, Brooke acknowledged that “the Board of Directors will also take such necessary steps to appoint a ‘financial expert’ or disclose in the Company’s annual report the fact that the Audit Committee and Board of Directors do not have a ‘financial expert’ in accordance with the Sarbanes-Oxley Act and AMEX requirements.”

105. The Charter Agreement also noted:

The primary function of the Audit Committee is to assist the Board of Directors in fulfilling its oversight responsibilities for financial matters, which includes, assisting the Board in the specific oversight of the integrity of the financial statements of Brooke, of Brooke’s compliance with legal and regulatory requirements, of the independence and qualifications of the independent auditor, and of the performance of the company’s internal audit function and independent auditors.
In so doing, the responsibility of the Audit Committee to maintain free and open means of communication between the Directors, the independent auditors, the internal auditors, and the financial management of the corporation.
Powers and Responsibilities
The power to recommend the accounting firm to engage as the company’s independent auditor. Factors considered in making that recommendation include, but are not limited to, the auditor’s independence, effectiveness, and fees.
The power to review the results of each external audit, including any qualification in the external auditor’s opinion, any related management letter, management’s responses to recommendations made by the external auditor in connection with the audit, reports submitted to the Audit Committee by the internal auditing department that are material to the Company as a whole, and managements responses to those reports.
The responsibility to investigate any matter brought to its attention within the scope of its duties, with the power to retain outside counsel, experts and other advisors as the Committee may deem appropriate in its sole discretion for the purpose if, in its judgment, that is appropriate. The Committee shall have sole authority to approve related fees and retention terms.

106. On April 22, 2004, Barnes replaced Leland Orr on the Audit Committee.

107. At the same time that Barnes replaced Leland Orr on the Audit Committee, the Brooke Corp. Board of Directors acknowledged that none of the members of the Audit Committee qualified as a “financial expert, ” as that term is defined by SEC regulations.

108. Pursuant to its appointment as Brooke’s independent auditor, SSC conducted an audit and prepared Brooke’s financial statements for the fiscal year ending December 31, 2004.

109. In connection with Brooke’s 2004 Form 10-K Annual Report (“2004 10-K”), SSC issued its opinion to the Brooke Corp. Board of Directors on March 4, 2005 stating:

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Brooke Corporation at December 31, 2004 and 2003, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 2004, in conformity with U.S. generally accepted accounting principles.

110. The 2004 financial statements were the first statements that recognized Initial Franchise Fee revenue.

111. From 2005 through 2008, at Brooke Corp’s annual meetings, the Audit Committee continually recommended, and the Brooke Corp. Board of Directors approved, the selection of SSC to perform Brooke’s annual audit.

112. Likewise, from 2005 through 2008, Brooke Capital's Board of Directors approved SSC to serve as Brooke Capital's external auditors.

113. From 2005 through 2008, the Audit Committee repeatedly recommended that the financial statements prepared by SSC be incorporated into the Company’s annual filings.

114. In each year from 2005-2008, SSC issued an opinion similar to its 2004 opinion that Brooke’s consolidated financial statements presented fairly, in all material respects, the financial position of Brooke and conformed to GAAP.

115. Neither Brooke nor the Audit Committee ever conducted any due diligence related to SSC, including whether SSC had ever audited a publicly-traded company or whether it had any experience auditing a franchisor. Nevertheless, the Brooke Corp. and Brooke Capital Board of Directors continually recommended SSC’s appointment.

116. Despite the fact that the Audit Committee was responsible for (1) the integrity and accuracy of the Brooke’s financial statements, and (2) ensuring that Brooke complied with all legal and regulatory requirements (including GAAP), and the fact that (3) no member of the Audit Committee was a “financial expert, ” the Audit Committee did not retain an outside financial consultant to help it interpret and understand the financial statements prepared by SSC, including the appropriateness of Brooke’s recognition of all Initial Franchise Fee revenue in the year it was received or the appropriateness of Brooke’s failure to properly record loan loss reserves associated with franchisees who were unable to service their debt. In fact, there is no record that the Audit Committee ever even considered retaining an outside financial consultant to assist them from 2004-2008.

117. Likewise, neither the Brooke Corp. nor Brooke Capital Board of Directors insisted that the Audit Committee retain an outside financial consultant to help it interpret and understand the financial statements prepared by SSC.

118. Accordingly, the Audit Committee, Brooke Corp.'s Board of Directors, and Brooke Capital's Board of Directors had no idea whether the financial statements prepared by SSC accurately reflected Brooke’s financial position or complied with relevant legal and regulatory requirements, including GAAP.

119. With no appreciation for the competence or quality of SSC’s auditing work, and despite the Audit Committees’ concern regarding SSC’s qualifications and competence, the Audit Committee, the Brooke Corp. Board of Directors, and the Brooke Capital Board of Directors continued to appoint SSC as their external auditors.

120. Nevertheless, each year, from 2004 through 2008, the Audit Committee continually recommended to the Brooke Corp. Board of Directors that it incorporate the financial statements for the respective years, which were audited by SSC and which represented that the financial statements accurately reflected the financial condition of Brooke, be included in Brooke’s annual report.

121. As a result, Brooke’s financial statements, which were included in its quarterly and annual filings with the SEC, and, as more fully set forth below, were in violation of GAAP and relevant SEC guidelines, resulted in material misrepresentations of Brooke’s financial condition.

V. Brooke’s Improper Accounting Practices and Its False Appearance of Solvency

122. In various SEC filings and disclosures, Brooke reported significant amounts of equity. This equity was, however, an illusion resulting from, among other things, Brooke’s improper accounting practices.

123. As discussed in further detail below, Brooke’s methodology for calculating loan loss reserves for franchisees that were unable to pay their loan obligations ignored the actual cash flows and financial condition of the underlying franchise, as required under GAAP, but instead relied on improper delinquency statistics created by Brooke.

124. Especially important, Brooke did not recognize Initial Franchise Fee revenue over the expected life of the franchise relationship, as required under GAAP and relevant SEC guidelines, but instead recognized all Initial Franchise Fee revenue at the inception of the franchise relationship despite the fact that Brooke had a continuing obligation to provide Franchisor Services in exchange for payment of Initial Franchise Fees.

125. If Brooke had properly followed GAAP and relevant SEC guidelines, its equity for 2003 through 2007 would have been as follows:

2003 (millions)

2004 (millions)

2005 (millions)

2006 (millions)

2007 (millions)

Equity

-$9.5

-$23.1

-$44.5

-$96.8

-$67.9 2

126. Succinctly stated, the Debtors were continuously insolvent from at least 2003 through their ...


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