Richard A. Levan & Associates, PC - Wall Street Journal

Friday, December 26, 1997

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Failing Returns

What Happened When A Small Town Trusted Local Financial Wizard

His Risky Investments Bring Fiscal Ruin, Dash Hopes For Improved Schools
Mr. Black Brought to Tears

By CHARLES GASPARINO And MICHAEL MOSS
Staff Reporters of THE WALL STREET JOURNAL

TYRONE, Pa. - Five years ago, when the Tyrone school district needed someone to invest its money, it turned to one of its own.

John Gardner Black's family had lived in the Appalachian hamlet for generations. His great-grandfather worked in the lumber yard; his parents started a chocolate factory that employed hundreds in this tough-times town on the banks of the Juniata River and Bald Eagle Creek.

From a tiny office downtown, Mr. Black created a financial empire of sorts. His company, Devon Capital Management, handled $3 billion in investments for schools and other public agencies in Pennsylvania and five other states.

So the district began giving Mr. Black almost everything it had: $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. "He showed us charts," recalls school superintendent William Miller, a childhood friend of Mr. Black's. "He was respected as a financial wizard, and he lives right here."

But instead of reaping a windfall, Tyrone stands to lose millions because Mr. Black invested the district's money in volatile bonds. The school project has begun but might never be finished. High-school students are working in closets, and the nurse is operating from what used to be the boys' bathroom.

Millions in Losses

Tyrone's fiscal crisis became apparent three months ago, when Mr. Black's firm was shut down by the Securities and Exchange Commission, which charged him with fraud. It says he lost millions in trading high-risk bonds, or derivatives, then hid the losses from new clients as he scrambled to recover. In a settlement with the SEC last week, Mr. Black agreed to make a payment to the government without admitting or denying wrongdoing.

Investigations by the U.S. Attorney's office in Pittsburgh and the U.S. Postal Service into Mr. Black's activities are continuing, and the Internal Revenue Service has interviewed former associates about the matter. When the SEC cashed out his accounts, about $70 million had been lost from the investments of 64 cash-strapped school districts in Pennsylvania and elsewhere. Tyrone had the largest stake.

Mr. Black, 53 years old, says his intentions were good, and that his clients knew the risks they were taking. His losses were temporary setbacks, he says, and he blames the securities regulators for pulling the plug too soon on a complex investment operation they barely understand. His lawyer, Richard Levan of Philadelphia, says Mr. Black "devoted his career to helping school districts."

The debacle is tearing Tyrone apart. Last month, a school-board meeting turned angry as nearly 100 residents demanded accountability from school-district officials over Mr. Black's actions.

"He ripped us off," says former Mayor Steve Beals, who attended the meeting, and fears the school complex might never be built Over at the local Moose Lodge, just two blocks from the Devon offices, no one is toasting the family's good health. Even at the Gardners candy store, across the street from the office where Mr. Black used to trade bonds, employees aren't coming to his defense.

Mr. Black's father, who is now retired after selling the candy business just this year, says the family is feeling the brunt of the town's anger. "We're thinking about moving to Canada," he says, "and to hell with it." It isn't his son's fault, he says. "The guy you want to blame is [Federal Reserve Chairman Alan] Greenspan," who raised interest rates in 1994, crushing Mr. Black's portfolio. "That's how it happened."

Lessons From Orange County

The case raises numerous questions about what, if anything, public officials have learned since the 1994 Orange County, Calif., investment debacle, in which the chase for big returns ended in a fiscal disaster. Mr. Black was using some of the same highflying bonds.

Then again, these far-flung, mostly rural school districts didn't get much guidance. Even now, Pennsylvania's two top finance officials can't agree on the simplest point: whether their public-investment law, considered by some to be the toughest in the nation, permits the kind of volatile investments made by Mr. Black. Moreover, there was a certain degree of denial among local officials - a general belief that Mr. Black's efforts could in no way resemble the big-city tactics that felled Orange County.

"We made mistakes," says R. Dean Fluke of the Huntingdon, Pa., Area School District board, which retained Mr. Black's services in 1994. "But I'm a dairy farmer," Mr. Fluke says. "My expertise is in borrowing money, not investing."

Yet Pennsylvania's own state auditors knew about potential problems even before the SEC pulled the plug, interviews with the auditors reveal. The regional bank Mr. Black used as a "custodian" for school-district money had received complaints from at least one school district about Mr. Black's investments as early as 1994. A federal court-appointed trustee in charge of sorting out the investment mess has also said he is looking at the role played by Kutak Rock of Omaha, Neb., a national law firm that advised Mr. Black on bond deals. Kutak declined to comment.

Even now, as he faces financial ruin and scorn from his hometown, Mr. Black remains confident in his ability to make money. Kicking off one of his brown loafers as he leans against a cabinet he launches into a description of his methods before the f eds came calling.

"I was hedged and profitable," he says, noting that beginning this year, his luck had turned: He was making some of the money back in the futures market. "Tyrone was making 22%," he said in a four-hour interview during which he characteristically stood and paced, slicing the air with his hands. "Why would you get out of that? Now it's gone."

The SEC defends its quick move, saying Mr. Black's explanations did little to change the decision to close him down. There was too much at stake, the SEC says. Coincidentally, the SEC official in charge of fraud nationwide, enforcement chief William McLucas, came from a cash-strapped school district in Pennsylvania that had $1 million invested through Mr. Black.

In Tyrone, the investment disaster came just as the town was trying to reclaim some of the glory it enjoyed as a major railroad center 130 years ago. "We had 62 trains stop here a day," says Suzanne Ohl, who maintains a historical display in a storefront on the main street "In the early days, we had a lot of good things."

When times got tough, as they did in the 1970s when the pulp mill laid off hundreds, Tyrone's main street was increasingly dotted with soaped-up windows and for-rent signs.

Mr. Black led the charge for Tyrone's rebirth. He bought up downtown parcels, including a 135-year-old hotel he says was slated for low-income housing. He opened an upscale men's clothing store and stocked it with Hickey-Freeman suits discounted to $795. He thought big, perhaps too big. His father, David Black, 76, says of the now-defunct store: "People in Tyrone wanted a suit with two pair of pants for $49."

He also opened a swanky restaurant around the corner, on the banks of the . Juniata River, and named it "Wharton's on the Juniata," after his alma mater, the Wharton School at the University of Pennsylvania. Entrees went for $9 to $14, but it was the $700 bottle of 1978 Haut Brion that people still talk about.

Mr. Black and his wife, Judy, belonged to the upper crust in Tyrone, population 5,100. They joined the Benedicts, a social club that caps its membership at 50, and at their ranch they kept horses and his-and-her BMWs. Over the years, Mr. Black supported building better schools in Tyrone. He regarded those who opposed him as "book burners," says friend and former business associate Milton Lopus.

But there is another side to Tyrone, represented by R. Jack Sloey, who parks a 1984 pickup truck in front of his brick home, spends Sundays at church and considers himself a lucky man at age 67 when his scope finds a four-point whitetail buck on a ridge in the misty hills above Tyrone. "Took me two hours to get it out" of the woods, says Mr. Sloey, a retiree whose career included selling water purifiers.

No issue divided the upper and working classes of Tyrone as did spending on new schools. In 1992, the school district firmed up plans for a project costing more than $20 million that would combine all four primary schools into one new building alongside a refurbished high school, which, proponents say, would eliminate a glaring disparity of test scores along socioeco-nomic lines.

Mr. Sloey represents a dissenting view that regards the project as a "Taj Mahal" aimed at empowering district officials at the expense of parental control. Mr. Sloey wanted to renovate existing neighborhood schools, and he waged a decade-long battle against Dr. Miller, the school superintendent Mr. Sloey lost his battle in 1992 when Dr. Miller and his supporters gained control of the school board. They sold bonds to finance construction of the centralized school facility and quickly turned to Mr. Black to invest the borrowed money.

On paper, Mr. Black's company looked unstoppable. Both he and his former partner, Mr. Lopus, had been officials in the state revenue department. Mr. Black hired former school-district business managers, and three former employees of the respected regional bank, Mid-State Bank, of Altoona, Pa., which had a branch next door to Devon in a three-story brownstone building with white pillars, gold leaf and a Herring-Hall-Marvin safe.

His clients became his best advertisers. For Christmas he would send baskets of Gardners candy, including the popular Peanut Butter Meltaway. The news spread that poor and rural school districts that used Mr. Black were earning tens of thousands of dollars more than those that didn't. The Daniel Boone school district became a repeat customer. So did Cumberland Valley, whose board president at the time, William Walsh, says the early returns Devon provided were "enough to make a difference" for the cash-hungry district.

SEC officials point to his use of turbo-charged securities, known as derivatives because they are "derived" from another underlying security, often a simple government bond. The ones Mr. Black turned to are designed to produce bigger returns for investors than plain-vanilla bonds - if interest rates fall. When interest rates rise, they can implode.

With Tyrone's money in hand, Mr. Black started losing money on his trades in 1994. He advised a number of school districts, including Tyrone, to place their investments in one big pool. He says he did so to produce even bigger returns, but investigators have told reporters that the pool allowed him to hide the true value of the school districts' investments.

In early 1996, he purchased another derivative, with a market value of about $14 million, using pooled client money, but valued the investment at $83 million-just enough to cover his losses, according to the SEC. Mr. Black defends the move, saying he arrived at the higher number by adding together all the future income the security could produce.

Some clients confronted Mr. Black about his practices. Beginning in 1994, the Huntingdon school district wanted to end its relationship with Mr. Black, after superintendent Francis Bames says he found "discrepancies" in the district's monthly account statements. Mr. Black attempted a refund by wiring a derivative to the school district. Dr. Barnes was furious, and complained to Mid-State about the matter. Mid-State declines to comment, but cites its answer to a lawsuit brought against it by another district, which also lost money with Mr. Black. The bank maintains it had no relationship with the district.

Two years later, Dr. Barnes relayed his experience with Mr. Black to the state auditor-general's office, which had launched an unrelated inquiry into school-district investments. Then-auditor-general Barbara Hafer wrote district officials warning them about investing in risky securities - so-called Collateralized Mortgage Obligations, or CMOs - after one district lost money. But her office had also been relying on none other than Mr. Black to provide it with information about the derivatives market from 1995 through the beginning of this year. The state never opened an inquiry into Huntingdon's dealings with Devon, it now says, because it had bigger matters to examine at the time.

How much of this made its way back to Tyrone? None of it, according to Dr. Miller. He and his business manager, Cathy Peachey, say Devon issued monthly reports showing no red flags in the district's investments. The Orange County affair was never much of an issue to them; they trusted Mr. Black.

Only last August did any bells start to go off, Dr. Miller insists. That's when Mr. Black, scrambling for more revenue, suggested that Tyrone enter into a bond deal called a "forward refunding" designed to save the district hundreds of thousands of dollars through the sale of new district bonds. Shortly after that, it dawned on Dr. Miller that there could be a problem with Mr. Black acting both as the district's adviser and as an owner of a separate firm that could profit from completing the deal.

"Isn't that a conflict-of-interest?" Dr. Miller recalls asking his old friend. Mr. Black, he says, shrugged. Mr. Black now says the matter is moot, because the talks went nowhere.

That's because the SEC and the FBI began dismantling Devon on Sept 26 after a routine audit by the SEC brought Devon's investing methods to light. A raid on his office at noon brought Mr. Black to tears. "I opened the door and 20 guys poured in behind me," he told his father that evening. Even the FBI agent who took part in the raid, Dale Frye, knew Mr. Black from Tyrone.

Mr. Black recalls begging for more time. "When they walked in the door, I thought, "They're going to seal these losses for these people and there's no reason for it.'"

That night Dr. Miller was leaving home to cheer on Tyrone's then-undefeated varsity football team, the Golden Eagles, when he got the bad news about Devon. En route to the game he phoned the one person who always had answers: Mr. Black. No one answered, he says.

Dr. Miller is now worried about his job. At a recent school-board meeting, residents took aim at Dr. Miller, saying he is just as much to blame as Mr. Black. He recently found himself in the uncomfortable position of debating his old nemesis, Mr. Sloey, on the local radio station. "This is a nightmare," Dr. Miller says at his cluttered desk in an elementary school, sifting through flies that detail the district's relationship with Mr. Black. "Even now I can't believe he did this."