There is no size in this idea and it’s not appropriate for a fund. It’s illiquid; plain and simple. This idea can be an attractive opportunity for someone with a smaller personal account. I’m conflicted about posting this idea because of these anti-VIC features and I’ll likely get some low ratings based on the size of the stock alone, but I find it might be worthwhile as a personal investment for some VIC members. There’s no reason to proceed any further if you cannot make an investment less than the $150,000 that is 10% of potential equity value of only $1.5 million.

Surety Capital Corp (SRYPQ) (“the Company”) is an illiquid nano-cap stock in bankruptcy that doesn’t have current financials (hasn’t filed numbers since Q3 06) and whose former CEO may have breached his fiduciary duty to the company. I came across the Company like most of us normally do. I woke up Christmas morning and read a local newspaper article discussing the Company’s bankruptcy filing.

The thesis here is simple. Surety Capital has three assets: Surety Bank (“the Bank”), and two potential causes of action: (1) a claim for breach of fiduciary duty against the former chairman, sole director(!), and CEO (Richard Abrams, hereinafter “Abrams”), and (2) a claim for recovery or cancellation of stock improperly issued to Abrams and his associates. The current market price is attractive when compared to the discounted value of these assets.

(02/28/07) http://www.sec.gov/Archives/edgar/data/784932/000078493207000006/sryp14a.htm

(07/10/07) http://www.sec.gov/Archives/edgar/data/784932/000078493207000010/sry8k-2007.htm

(08/15/07) http://www.sec.gov/Archives/edgar/data/784932/000078493207000012/sry8k-2007.htm

(10/01/07) http://www.sec.gov/Archives/edgar/data/784932/000078493207000014/sryp8k.htm

(12/14/07) http://www.sec.gov/Archives/edgar/data/784932/000135448807002104/form8kdec07k.htm

(12/25/07) http://www.star-telegram.com/business/v-print/story/377287.html

(12/26/07) http://www.sec.gov/Archives/edgar/data/784932/000135448807002164/ex991.htm

The Bank

A bankruptcy sale of the Bank will likely (not certainly) bring $9 million. According to bankruptcy filings, “[t]he Bank is unprofitable, but its tangible book value is approximately $6 million. . . . [the Company] believes the Bank is worth at least $9 million or 1.5 times book value.” Now where did this $9 million come from?

Surety Capital already had an offer from Pax Holdings for $9.513 million. See http://www.sec.gov/Archives/edgar/data/784932/000078493207000006/sryp14a.htm . That offer fell through. See http://www.sec.gov/Archives/edgar/data/784932/000078493207000010/sry8k-2007.htm . Why did the deal fall through? According to bankruptcy filings, “[t]he prior controversies regarding [Abrams’s] self-interested management have tarnished the Bank’s reputation and hindered previous efforts to sell the Bank outside of bankruptcy.”

Jerry says that Pax Holdings is not the unidentified bank that has offered $8.5 to $9 million for the Bank but that the Company currently has such an offer. See, http://www.star-telegram.com/business/v-print/story/377287.html . This offer appears strong enough for the Company to actually state, in its debtor’s schedules, $9 million as the value of its 100% stock ownership of the Bank. I’ve talked to Jerry, and my understanding is that [1] the Company had/has a pre-filing offer; [2] Jerry realized Abrams and his son (owning 18% combined) are going to object to the sale; [3] can bypass Abrams by selling whilein Chapter 11; and [4] can attempt to recover shares issued by Abrams to himself and his friends (see below).

So we have a range of enterprise value (TEV) of $8.5 to $9 million. Let’s figure out the equity value. The Company has $6.7 million in liabilities; the largest liability is $6.4 million in publicly traded debentures. (Note: I don’t have any price information on these. Given that I’m writing an investment thesis for the most junior claim—equity—any debentures that can be bought for distressed, or even stressed, prices may prove more attractive. Of course, do your own due diligence on these debentures if they’re available.) According to bankruptcy filings, “[t]he debentures mature on March 31, 2008 and [the Company] has no cash with which to pay them. The debenture holders have sued for failure to make scheduled interest payments. A sale of the Bank is the only way to generate the cash necessary to pay off the debentures at maturity. Properly advertised and managed, a sale should generate sufficient proceeds to pay all creditors in full and make a meaningful distribution to shareholders.”

With 15 million shares outstanding (but this number is contested, see below), the current price of $0.13/share puts equity value at $1.95 million. Assuming a sale of the Bank at $9 million, the value leftover for equity—after $6.7 in liabilities—would be $2.3 million or $0.1533/share. This unadjusted return is 17.95%. At a sale price of $8.5 million, the value leftover for equity—after the $6.7 in liabilities—would be $1.8 million or $.12/share. This unadjusted return is -7.69%.

The Bank is only one of the three assets the Company has. Let’s check out the other two.

According to bankruptcy filings, “[t]he [Company] was mismanaged for a long period of time by [Abrams], who is also one of the Debtor’s largest single shareholder. In addition, [Abrams’s] son [], the Abrams Family Trust, and [Abrams’s] girlfriend are also substantial shareholders.” Abrams owns 10.7% and Rodney Abrams owns 7.95% of the Company. This is why, according the newspaper link above, “[Jerry] Weiner, chairman and chief executive of Surety Capital Corp. since Oct. 1, described the Chapter 11 move as a means to overcome possible shareholder opposition to a desired sale of the holding company.” Again from bankruptcy filings, “[Abrams] has been prohibited from engaging in certain activities in the banking industry as documented by a June 2007 Consent Order, effective October 1, 2007.” See http://www.sec.gov/Archives/edgar/data/784932/000078493207000012/sry8k-2007.htm .

According to an article entitled, “Pax Kills Surety Bank Deal,” published July 11, 2007, “[i]n February the Office of the Comptroller of the Currency charged that Surety Capital's chairman and chief executive officer, Richard Abrams, used unsafe and unsound banking practices, and in June it barred him from the banking industry and required him to pay a $15,000 fine.”

The Company has listed “Potential Claim Against former management for breach of fiduciary duty” as an asset on the debtor’s schedules. The current value is listed as “unknown.” I’m unsure what the Company might get in pursuing a potential claim for breach of fiduciary duty against Abrams. My sense is that it may be used as leverage in pursuing a claim for recovery or cancellation of stock improperly issued to Abrams and his associates.

Following Jerry’s appointment as Chairman, see
http://www.sec.gov/Archives/edgar/data/784932/000078493207000014/sryp8k.htm, he discovered that there had been 3.5 million shares issued to Abrams and his associates, see
http://www.sec.gov/Archives/edgar/data/784932/000135448807002104/form8kdec07k.htm .

In my non-insider opinion, the Company would have a good shot at recovering under § 547 of the Bankruptcy Code as an insider preference. Under § 547, the Company can look to payments made to insiders a year before the bankruptcy filing, and no presumption of insolvency is needed. The Company will have to show that Abrams and his associates received more value than they would have received if the bankruptcy case were a Chapter 7 liquidation. My only input here is that courts generally view Chapter 7 values as very low, because courts use fire sale prices and large chapter 7 trustee administration fees.

If the company can recover the 3.5 million shares issued, then the ‘true shares outstanding’ will total 11.5 million. This would change the value of equity dramatically. With 11.5 million shares outstanding, the current price of $0.13/share puts equity value at $1.5 million. Assuming a sale of the Bank at $9 million, the value leftover for equity—after $6.7 in liabilities—would be $2.3 million or $0.20/share. This unadjusted return is 53.85%. At a sale price of $8.5 million, the value leftover for equity—after the $6.7 in liabilities—would be $1.8 million or $.1565/share. This unadjusted return is 20.40%.

I’ve used a 50/50 chance of a $8.5 or $9 million sale price. I’ve also used a 50/50 chance of the Company recovering the shares issued to Abrams and his associates. This results in an expected return of over 20%.

(all $’s in millions)

A couple of other ‘share recovery’ scenarios give attractive returns as well.

    Actual IRR could be less, though likely not substantially less, as the bankruptcy process might take over a year towards 18 months.