Inside the downfall of a deal-making duo

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The cover-up, according to provincial regulators, began even before the deal was done.

In the fall of 2016, Larry and Phillip Smith, the father-son duo in charge of Vaughan, Ont.-based PACE Savings & Credit Union Ltd., hit a snag as they worked on a plan to buy a currency exchange business. The seller was offering a 75-per-cent stake. A transaction of that size would require consent from the Deposit Insurance Corp. of Ontario, or DICO.

Rather than ask permission, the two men allegedly devised a way to work around the provincial regulator, according to court filings. On Dec. 7, 2016, PACE chief executive Phillip Smith e-mailed his father, suggesting that “we do our best to keep this [deal] arms’ length."

“The regulators will find this eventually,” he wrote at 8:26 a.m., “but I think if we can ‘put’ them off for next year it won’t matter … which is why we do what we can to keep any ‘direct’ connection away from DICO in the interim.”

That afternoon, Larry Smith, who had been PACE’s CEO for 28 years and was still its president, replied. “Yes exactly my thoughts,” he wrote, adding, “anyway best this not be decided or discussed via email."

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The repercussions of that scheme are still reverberating more than two years later. Last September, DICO took control of PACE, invoking a rarely used power reserved for stabilizing firms in serious financial or operational distress. In December, the regulator fired Larry and Phillip Smith without severance.

Allegations that the Smiths hid the true size of PACE’s holdings in the currency-exchange company, and diverted payments to themselves and an acquaintance, have spilled out in court filings, although those allegations have not been proven.

Last month, Ontario’s Superior Court froze assets belonging to Larry and Phillip Smith, their families and numbered companies the duo control. A list of those assets offers glimpses of a lavish lifestyle: It includes property on two islands in Georgian Bay, a 4,000-square-foot house in Florida, three boats and an Aston Martin DB9, the US$175,000 car made famous in James Bond movies.

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According to the regulator, in the currency-exchange deal, Larry Smith also had an unlikely partner: a Toronto-based real estate agent named Joanna Whitfield with whom he had a close relationship, and who controls an obscure numbered company that had defaulted on loans from PACE before.

The Smiths are no strangers to deal-making. Larry Smith built PACE over three decades through acquisitions and mergers with smaller credit unions, and it now has more than $1-billion in assets and 16 branches across Southern Ontario. Phillip had served as chief financial officer before he succeeded his father as CEO, but Larry stayed deeply involved.

The allegations in the court filings raise questions about apparently lax oversight and regulation of credit unions. The conduct at issue dates back several years, and the regulator has not made public all of its “significant concerns involving various governance issues,” according to an affidavit DICO filed in court.

Credit unions operate on a member-driven model, with locally elected boards of directors. For some customers, the co-operative model is more attractive than Canada’s big banks: Members are part-owners with voting rights over the credit union’s affairs, and share in profits it generates. But most credit unions cannot match the resources the major banks devote to compliance controls. Canada has about 250 credit unions with 5.7 million total members and combined assets of $230-billion, while the six largest banks have a total of $5.4-trillion in assets.

Regulation of credit unions is patchwork. There are some federal credit unions regulated by Ottawa, but most are regulated provincially, and oversight is divided between agencies.

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DICO, which insures deposits at credit unions in Ontario, says it acted appropriately in the PACE case. “DICO, as Administrator, has been proactive in protecting members and has acted decisively in their interest,” chief executive officer Guy Hubert said in a written statement. “Our objective is to ensure that any further necessary corrective actions are taken so that PACE will be released from Administration in due course.

"These events are not impacting the current day-to-day operations of PACE. It is important to note that there is a strong foundation at PACE and all operations remain business as usual.”

A lawyer for Larry Smith, Alistair Crawley, said in a written statement to The Globe and Mail that “The administration order was made without notice to Mr. Smith or PACE’s management, and neither the board of directors nor management was provided any opportunity to respond." He added: "Mr. Smith strongly disagrees with DICO’s characterization of the [currency-exchange] transaction and intends to defend the proceeding commenced by DICO should it move forward.”

Phillip Smith declined to comment and his lawyer did not respond.

What follows is based on allegations outlined in court documents filed by DICO on behalf of PACE. The allegations, which are supported by extensive documentary evidence and sworn statements, have not been proven in court.

After an anonymous whistle-blower contacted DICO, the agency launched an investigation that gave it a “high degree of confidence that Larry and Phil had undertaken a number of improper or illegal transactions for their own benefit and, as a result, they had at a minimum breached their fiduciary duties to the Credit Union," according to court documents filed by DICO.

Although the regulator has not filed a statement of claim against Larry or Phillip Smith, "the totality of the evidence … is such that the Administrator has concluded that there can be no reasonable explanation for their conduct,” DICO told an Ontario court.

‘Just between ourselves’

PACE’s roots stretch back more than 60 years. It began as the credit union for employees of Peel Region, west of Toronto, and now has 16 branches in Ontario stretching from Whitby to London.

Larry Smith was named CEO in 1988, and has been PACE’s driving force ever since. In addition to expanding the business, he also courted politicians. In 2014, when he created an investment dealer subsidiary, PACE Securities Corp., former Ontario premier Ernie Eves was named chairman of the new unit. In April, 2018, Frank Klees, a cabinet minister in Mr. Eves’s short-lived government, joined PACE’s board.

The deal that would lead to Mr. Smith’s downfall took shape in late 2016. He wanted PACE to buy a stake in Continental Currency Exchange Canada Ltd. (CCE), a family-run currency-exchange business with 19 branches across Ontario.

PACE executives pitched the credit union’s board on the potential to sell services through CCE’s branches and kiosks, generating new profits. Originally, PACE planned to partner with The Mint Corp. Inc., a financial-technology company, to jointly acquire CCE through a special-purpose vehicle.

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But in October, 2016, CCE founder and CEO Scott Penfound e-mailed Larry Smith, proposing that they “do a deal just between ourselves.” Mr. Penfound suggested PACE could acquire 75 per cent of CCE’s shares. (Mr. Penfound declined to comment.)

Credit unions are barred from acquiring more than 30 per cent of a company’s shares, or setting up a subsidiary, without the provincial regulator’s consent. Executives at PACE knew that rule well: The credit union had applied for such approvals before, and in December, 2014, DICO had formally censured PACE for failing to get consent to acquire a subsidiary.

So, when PACE and CCE drafted a letter of intent on Nov. 3, 2016, the letter stated that PACE would acquire 30 per cent of CCE’s shares and “a company to be incorporated” would buy a 45-per-cent stake. Subsequent shareholder agreements left the other buyer’s name blank, or referred to it as “[Buyer 2].”

The following month, an odd candidate emerged for that large stake: 2340938 Ontario Ltd. The numbered company, called “2340” for short in court documents, had been incorporated years earlier, in 2012, just before it acquired the assets of a poultry business that had borrowed money from PACE.

The regulator alleges that 2340 was created specifically for this purpose. The poultry business, Trayco Processing Inc., was struggling, and one of Trayco’s shareholders was another numbered company owned by Alison Golanski, Larry Smith’s common-law partner. Late in 2012, when Trayco defaulted on $3.5-million in loans from PACE, the credit union “conveyed" Trayco’s assets to 2340 through a sale, DICO alleges.

Yet, 2340 only had the funds to buy Trayco’s assets because, under Larry Smith’s direction, PACE provided 2340 with a separate loan of $2.2-million, as well as a $300,000 credit line, according to the regulator. Because 2340 used that new loan from PACE to purchase Trayco’s assets, those funds could then offset some of the credit union’s losses on its earlier loans to Trayco, which were in default.

“This form of circuitous lending had the effect of making it appear that the Credit Union had fully realized on the loan to Trayco when in fact it had not,” DICO alleges.

Ms. Golanski referred questions to a lawyer, who declined to comment.

After that, the business operated for a time as Premier Poultry Products, owned by 2340. But it was actually run by Larry Smith and Brian Hogan, PACE’s vice-president of commercial lending, according to DICO. They failed to make Trayco’s business successful, however, and 2340 ultimately defaulted on its loans. PACE wrote off $2.9-million in losses in 2016. “While the assets of the poultry business appear to have been disposed of, 2340′s loans to PACE were not repaid in full," and it appears that PACE never undertook enforcement proceedings to recoup its losses, DICO alleges.

The sole officer and director of 2340 is Ms. Whitfield, the real estate agent, who had no apparent experience in poultry, according to the regulator. Larry and Phillip Smith would later tell DICO that Ms. Whitfield was “just a regular customer and business partner” of PACE. But DICO says “those statements appear to be false."

‘2340’

Early in 2017, 2340 had been reduced to an empty shell: The company had no employees, capital or assets, having lost its interest in the poultry business, and its debt to PACE from the Trayco deal was still unpaid. But when PACE agreed to buy 30 per cent of CCE’s shares, 2340 bought the other 45-per-cent stake for $14.27-million, and PACE loaned it the money, the court filings allege.

PACE’s board approved the CCE transaction, which closed Jan. 31, 2017, but the provincial regulator says it’s “not clear” if it had been fully advised of the details.

To finance 2340’s purchase of its stake, Larry Smith “caused PACE” to provide 2340 with a $14.5-million interest-only loan, and a $500,000 line of credit purportedly for “working capital purposes.” It’s also unclear whether PACE’s board knew of the loan, according to the regulator.

But it alleges that 2340′s cheque book and accounting software were kept at PACE, controlled by Larry Smith’s personal assistant, and court exhibits show that his assistant used a stamp of Ms. Whitfield’s signature to draw cheques on 2340′s account, allegedly on Larry Smith’s instructions.

DICO alleges that Ms. Whitfield likely had a “physically intimate” relationship with Larry Smith. In e-mails, he refers to Ms. Whitfield as “darling,” and signs off, “Love ya,” to which Ms. Whitfield responds, “Love you too xxxoo.”

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In other e-mails, they discuss a downtown Toronto condo in Ms. Whitfield’s name that they own together. Two mortgages registered on the property were provided by Larry Smith and a numbered company registered to him, according to property records. Larry Smith also appears to discuss helping pay for plastic surgery for Ms. Whitfield, who sent before-and-after photos filed as a court exhibit.

Larry Smith “vehemently denies the salacious and gratuitous description of the personal relationship between himself and Ms. Whitfield,” said his lawyer, Mr. Crawley.

In an e-mail to The Globe, Ms. Whitfield said, “if this matter proceeds, I plan to vigorously defend myself. As always, there is another side to the story."

Two months after the CCE deal closed, a commerical banker at Bank of Montreal who handled the currency-exchange company’s accounts began asking questions. The bank needed information about the beneficial ownership of CCE’s accounts, now that CCE had new shareholders. Before long, BMO also launched a routine anti-money-laundering review.

In a Mar. 13 e-mail exchange with Phillip and Larry Smith, Mr. Penfound, CCE's chief executive, drafted a response to BMO that would describe PACE as having acquired a “controlling interest” in CCE.

In response, Phillip Smith asked that the language be “softened.” “The importance for us is PACE is not to be seen ‘cosmetically’ in control of CCE,” he wrote.

In October, 2017, BMO’s banker asked more pointed questions about the close relationship between PACE and 2340, surmising that it provided PACE with "the ‘comfort’ of indirect control” of CCE.

Mr. Penfound tried to assuage the bank’s concerns in a letter, allegedly edited by Larry Smith, that cited Ms. Whitfield’s 15-year track record as a PACE customer. Mr. Penfound’s banker at BMO did not respond to messages, and a BMO spokesperson declined to comment.

That same month, DICO first learned about the CCE deal “through a letter from an anonymous whistle-blower.” The regulator calls 2340′s role in the deal “a sham.”

“[It] is not commercially reasonable or prudent for a financial institution to lend an insolvent company almost [500 per cent] of the amount of the unpaid debt in hopes that its new investment would be sufficiently profitable to repay the old $2.9-million debt as well as the new loan of $15-million,” a senior DICO officer wrote in an affidavit.

Mr. Crawley, Larry Smith’s lawyer, vigorously defended the deal in his statement to The Globe.

“[Larry] Smith states that the CCE transaction, which is the subject of DICO’s legal proceeding, was a bona fide transaction that was unanimously approved by PACE’s board of directors. The transaction has been highly profitable for PACE and should continue to be, notwithstanding DICO’s intervention. DICO’s proceeding against Mr. Smith is purely tactical as PACE has suffered no damages.”

‘Excess funds’

After the CCE deal closed in early 2017, significant payments began to flow from CCE to 2340 and, by extension, to the Smiths and Ms. Whitfield, according to the regulator.

DICO alleges Larry Smith received $50,000 from 2340 after the deal closed, while Phillip Smith received $50,000 in cheques made payable to his son.

A disclosure notice filed by Ms. Whitfield with PACE’s board details plans to divide payments totalling up to $300,000 annually between her, Larry and Phillip Smith and other redacted individuals for serving as directors and officers of 2340, or providing consulting services.

E-mails from April, 2017, describe the potential for a recurring $525,000 payment from CCE to 2340, and Larry Smith asks Mr. Penfound to send the funds to PACE’s address, to the attention of him and his assistant. Mr. Penfound subsequently amended the amount to $450,000 – the quarterly dividends CCE agreed to pay to 2340.

Those funds allowed the numbered company, 2340, to make about $240,000 in quarterly interest payments to PACE on its loan, leaving substantial excess funds. “These excess funds are being used to, among other things, make payments to Whitfield for no apparent reason,” DICO alleges.

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One exhibit includes 2340′s bank account statements, showing $141,000 in payments to Ms. Whitfield between February, 2017, and October, 2018.

The Nov. 1, 2018, dividend of $450,000 appears to have been diverted from 2340′s account at PACE to an account at Royal Bank of Canada, in violation of PACE’s loan agreement, according to the regulator. Ms. Whitfield has an RBC account. An RBC spokesperson declined to comment.

In a Feb. 15, 2018, e-mail to Mr. Penfound, Larry Smith says: “At this point we’ve paid JW’s co … $1.35m … should it be classified as a dividend and/or management/consulting fee,” with DICO presuming JW is Ms. Whitfield.

Despite holding the same class of shares as 2340, PACE did not receive dividend payments it was due to be paid by CCE, according to DICO.

PACE’s audited financial statements for 2017 reported that Larry Smith was paid $636,010 and Phillip Smith earned $511,750. But in an affidavit, DICO says the duo received far more.

“In fact, once all of the extra payments Larry and Phil received in relation to the Credit Union’s business are accounted for, Larry received (directly or indirectly) approximately $3.84-million and Phil received at least $225,000 more than the reported amount in 2017 alone.”

The Smiths appear to have been living well. A four-page annex to the court order that froze their assets last month lists just some of their holdings. There are the two island properties in Georgian Bay and two properties in Naples, Fla., including the 4,000-square-foot home, which was recently listed for sale for US$1.25-million. There are the three boats, three Sea-Doos, the Aston Martin DB9, artwork that includes a print by Marc Chagall and a wine collection insured for $50,000.

Most of the documents from this latest court proceeding are kept confidential under a sealing order issued by a judge. “The Administrator commenced legal proceedings to protect the best interest of the credit union members as part of its process to deal with the past governance issues," Mr. Hubert said in a written statement.

The order to freeze assets also lists Larry Smith’s common-law partner Ms. Golanski, Mr. Klees, the former Ontario politician, and Mr. Hogan, PACE’s former head of commercial lending, as co-defendants. Mr. Hogan could not be reached for comment.

In an e-mail, Mr. Klees said “the Smith family are long time friends,” and that PACE has been a client of his consulting company “for a number of years," but that all fees “have been transparent and fully disclosed by my company and by Mr. Smith on behalf of Pace Credit Union.” As for why the court order names him as a defendant, “I myself am at a loss to understand,” Mr. Klees said, referring questions to his lawyer, Michael Cohen, who did not respond to requests for comment.

Months after DICO was first contacted by the whistle-blower in October, 2017, the regulator sent PACE a letter of concern the following March. In April, 2018, the regulator met with several people at PACE, including with Larry and Phillip Smith. During that meeting, “DICO found much of the information to be incomplete or inaccurate,” the regulator alleges.

PACE directors also expressed concerns to DICO, and in May, DICO engaged KSV Advisory Inc. as a special auditor and examiner, and met privately with PACE’s board. Four months later, DICO seized control of PACE using an administration order – a power it last used in 2012 – citing unspecified “governance issues.”

Shortly before DICO issued its order, Ms. Whitfield had drafted an invoice to sell all shares in 2340 to Larry Smith for $250,000, noting he had already paid her $25,000. But it appears that deal was never completed. An Ontario judge later granted DICO an order placing 2340 in receivership, securing its assets.

Last Dec. 5, DICO dismissed Larry and Phillip Smith with cause. The regulator alleges that it has found additional evidence confirming “that Larry and Phil were engaged in an improper scheme to evade the requirements of the [Credit Unions and Caisses Populaires] Act and the Regulations and, furthermore, to enrich themselves and others connected to them through the CCE Transaction.”

DICO also disbanded PACE’s 12-member board and, in January, appointed Rubina Havlin as the credit union’s interim CEO. Ms. Havlin is the former CEO of Wealth One Bank Canada, and was not available to comment.

At PACE, business carries on under the regulator’s watchful eye. But for Larry and Phillip Smith, the investigation of the CCE deal may only be the start of their legal troubles.

In an affidavit, DICO states that “the irregularities and the concerns regarding the CCE Transaction were only one of the issues that lead DICO to issue the Administration Order.”