Charity Lends a Hand to Prisons With Murky Off-the-Books Deals

May 1, 2002

FOLKSTON, Ga. -- At the D. Ray James Prison in south Georgia, the inmates have been kept behind bars by all types of lawmen: sheriffs, chiefs of police and more than a few wardens. But never, until now, have they been kept in jail by a charity.

In August, a partnership headed by Provident Foundation Inc., a not-for-profit group based in Baton Rouge, La., bought the prison, a 1,500-man compound on the edge of the Okefenokee Swamp. Corrections experts say they don't know of another example in recent times of a charity owning a prison.

Provident isn't a conventional charity. It is run by a group of lawyers, investment bankers and financial consultants. Lehman Bros. Holdings Inc. and other Wall Street titans do its financial work.

Unique Niche

With that impressive firepower, Provident is trying to carve a unique niche for itself in the corrections world, offering off-the-books financing for public and private prison operators. It has helped the state of North Carolina and Cornell Cos., a for-profit prison company, buff their financial profiles. Provident does this by creating special subsidiaries and partnerships that take advantage of controversial accounting rules and allow its clients to keep debt off of their balance sheets.

In exchange for its role, Provident arranges to receive potentially lucrative fees, some of which it calls exempt from federal income tax. In the last nine months Provident entities, with help from Lehman, have sold more than $420 million of debt to investors. That money has been used to build or acquire six prisons, as well as eight halfway houses and other facilities, from the Alaska tundra to Georgia's famous swamp. Provident says one of its charitable purposes is easing the government's burden of building and running prisons.

As scrutiny of complex accounting grows in the wake of the Enron Corp. collapse, Provident offers the unusual twist of a nonprofit playing the off-the-books game. The foundation's major deal with Cornell sparked an embarrassing restatement of the Houston-based company's financial figures last month. The company's top official has been stripped of his titles as chairman and chief executive.

Provident got its start in September 1999, when Steve E. Hicks, a politically active Baton Rouge bond lawyer, formed the venture with his brother, Donovan, and Joseph H. Torrence, an ex-managing director with the former Shearson Lehman Bros. Mr. Hicks, now 53 years old, served as a member of the national finance committee for the Clinton/Gore campaign in 1992. In 1995, President Clinton appointed him to the advisory committee of the John F. Kennedy Center for the Performing Arts in Washington.

Mr. Hicks was soon joined on Provident's board by others with connections in Washington and on Wall Street. One is Thomas H. Hudson, former chief of staff to U.S. Sen. John Breaux of Louisiana and a partner in the Washington office of the law firm Brownstein Hyatt & Farber. Another is J. Dan Hall II, first vice president of private-client investment at UBS PaineWebber in Atlanta, a unit of Switzerland's UBS AG.

Provident initially told the Internal Revenue Service in a September 1999 application for tax-exempt status that it intended to acquire and operate nursing homes. Provident told the government it would be "operated exclusively for public charitable uses."

In a May 22, 2000, letter to the IRS, Mr. Hicks said his desire to form the charity stemmed from his "genuine passion and concern for health care, especially senior citizens." He also said he was looking for a more rewarding second career after logging some 700 bond closings over 25 years as a lawyer. "Call it burnout," he wrote.

The IRS granted Provident's application in June 2000. Provident went on to acquire a dozen nursing homes and moderate- and low-income housing projects in five states.

By the time the foundation acquired tax-exempt status, its focus had already broadened to include prisons. Mr. Hicks says that Provident's board expanded its mission to include "assisting state and local governments in alleviating their burdens" in housing inmates. The IRS recognizes "lessening the burdens of government" as a legitimate purpose for nonprofit organizations.

Many states and private prison companies that had piled up debt in the prison-building boom of the 1990s had grown reluctant to finance additional construction themselves. North Carolina wanted more cells but sought to finance them off of its own books. It invited bids from contractors willing to borrow the money for the construction.

Carolina Corrections

In April 2001, Provident formed a subsidiary, Carolina Corrections LLC, to bid for a contract to build three 1,000-bed prisons for North Carolina. Provident's unit underbid two competitors to get the job. The state agreed that upon completion of the three prisons in 2004, a special-purpose state corporation would buy the facilities from the Provident unit for $224 million and then lease them to the North Carolina corrections department for 20 years.

This arrangement allows North Carolina to avoid borrowing more money itself at a time when its budget deficit has grown. But in the long run, renting could cost the state more than simply building the prisons itself. North Carolina's nonpartisan fiscal-research division has estimated the 20-year-lease expense as $370 million. That's $146 million more than the $224 million purchase price.

Bob High, the state's deputy treasurer, says North Carolina could have saved money over the long term by financing the deal itself. But he adds that Provident's subsidiary can get the job done more quickly.

Mr. Hicks says he isn't familiar with the state fiscal-research projection. "We know we have substantially lowered the cost associated with operating the facilities in North Carolina," he says. He says he can't quantify the savings beyond that it is "in the millions of dollars."

The Provident unit's gross income from the deal, before interest expense, is expected to be $20 million, according to documents describing the transaction. The unit also will receive a separate "development fee" and a monthly "administrative-oversight" fee, Mr. Hicks says, but he declines to specify those amounts. He says all of the proceeds would be tax-exempt and can be passed along to Provident itself.

The foundation hasn't yet made the required filings with the IRS covering the North Carolina deal. Ken Hubenak, an IRS spokesman, declines to answer questions about Provident's activities, noting that the agency doesn't comment on specific organizations.

For selling the bonds for the project, Lehman will receive a fee in excess of $2 million, according to people familiar with the deal.

David Lavelle, Lehman's lead banker on the North Carolina transaction, served as a crucial intermediary on Provident's next prison deal. In mid-2000, according to Mr. Hicks, Provident was looking for more business when Mr. Lavelle suggested a potential prospect: Cornell Cos.

The prison company had grown rapidly since going public in 1996. Its revenues had risen more than five-fold, as it acquired dozens of prisons, halfway houses and juvenile-detention facilities. The No. 4 player in the private-corrections field, Cornell had roughly 7% of the market, behind such companies as Corrections Corp. of America and Wackenhut Corrections Corp.

But its acquisitions had left Cornell deep in debt. By 2000, Mr. Lavelle approached the company with a sweeping solution to its debt problem, according to Cornell's chief financial officer, John Hendrix. Lehman had already been working with Cornell on other matters.

The solution called for Provident to create a subsidiary that would act as the general partner of a limited partnership called Municipal Corrections Finance LP. On Aug. 14, 2001, the partnership paid Cornell $173 million for 11 correctional facilities, and then leased them back to the company.

On the surface, nothing changed. Cornell continued to run the facilities. But now it was the tenant, not the owner. Cornell used proceeds from the "sale-leaseback" to pay off nearly all of its debt. Sale-leasebacks are commonly used to raise cash by companies that own real estate.

Lehman financed the deal, selling bonds to large, private investors, with net proceeds of $165 million. But Cornell's goal was to remove debt from its books, not add more. It treated Municipal Corrections as a separate entity responsible for the debt. To do that under accounting-industry rules, the partnership had to have independent equity investment of 3% or more.

Lehman and Provident essentially split this requirement, with the investment bank providing most of the outside cash and the charity providing independence, according to documents outlining the deal. Lehman became a limited partner of Municipal Corrections, investing $8.2 million for an equity stake of more than 3%. Provident retained control of the venture as general partner but invested only $82,525.

Steven L. Schwarcz, an expert on off-balance-sheet financing at Duke Law School, says that having two investors collaborate in this way to meet the 3%-independent-investment rule is unusual. But, in theory, it could be permissible, if Provident is truly independent of Cornell, he says.

In return for helping to cleanse Cornell's books of debt, Lehman and Provident expected rewards. Lehman is to collect a $2 million fee for selling the bonds, according to the deal documents. It also received rights to 99% of the rent Cornell pays the partnership, after payments to bondholders. Deal documents indicate the amount could be $2.4 million a year.

Provident is supposed to take the remaining 1% of the partnership's cash flow after bondholder payments, plus an unspecified fee in the event it should sell its general partnership interest.

Mr. Hicks says he doesn't know how much Provident's 1% will amount to. But he says the Cornell deal isn't intended as a charitable endeavor, and any Provident income would be taxable. "The transaction was no different than had Provident determined to invest funds in a government obligation," he says. For this reason, he adds, it is irrelevant whether the deal lessens the burdens of government. The transaction does afford Provident an opportunity to explore the development of "special care and housing for aged and infirm inmates," Mr. Hicks adds.

Lehman's Mr. Lavelle declines to comment. Lehman spokesman William J. Ahearn says the accounting treatment of the Cornell transaction was proper.

The deal appealed to Cornell's then-CEO, Steven W. Logan, he says. Prior to joining Cornell in 1993, Mr. Logan had worked for Cornell's auditor, Arthur Andersen LLP, in Houston. At a June 2001 forum in New York, Mr. Logan, now 40, told Wall Street analysts of the debt-ridden prison industry, "There is a financing transaction that we are working on that, if successful, will change our entire industry."

Stock Boost

News of the pending deal helped drive Cornell's stock to new highs. Cornell's shares, which had traded for as little as $3.50 in the fourth quarter of 2000, were trading for more than $17 a year later. Last November, about three months after the sale-leaseback, Cornell sold another 3.5 million shares. The lead underwriter handling the sale was Lehman, which collected a $2.1 million fee, according to filings with the Securities and Exchange Commission.

Although publicly traded, Cornell stock is held by relatively few investors. As of March 31, there were only 34 common stockholders of record. Among them were Mr. Logan and a group of private investment funds based in the Cayman Islands and Bermuda, both considered tax havens.

Early this year, Cornell's stock continued to rise. But on Jan. 31, its auditor, Andersen, sent a troubling letter to members of the Cornell board's audit committee. Acting after it had come under fire for its auditing of Enron, Andersen questioned the purpose of an unusual $3.7 million retainer Cornell last August had agreed to pay Lehman. The retainer wasn't linked to a specific assignment but was supposed to pay for work Lehman might do in the future.

Andersen questioned whether in fact the retainer amounted to a partial payback for Lehman's equity investment in the Municipal Corrections partnership. If this were the case, outside investment in the partnership would fall below the 3% requirement, undermining the notion that the partnership's debt could be kept off Cornell's books.

Six days after receiving the letter, Cornell announced plans to review its accounting of the August sale-leaseback. Its stock fell 43% in one day.

Mr. Logan says the retainer "represents a legitimate arms-length transaction to pursue separate future projects that are unrelated to the 2001 sale-leaseback." Lehman's Mr. Ahearn says the retainer "was entirely separate from the investment we made" in the Municipal Corrections partnership.

There was another complication: Mr. Logan had struck a side deal with Provident. In July 2000, he formed similarly named Municipal Corrections Inc., a Texas corporation for which he is the sole director, according to the Texas secretary of state's office. The side agreement gives the Logan company the right to buy from Provident and its subsidiary their interests in the partnership that now owns the former Cornell correctional facilities, according to a copy of the agreement reviewed by The Wall Street Journal. The side deal specifies neither a price nor date for this sale.

If this side agreement went into effect, Cornell would no longer be renting its prisons from Provident, an independent third party. Cornell would be renting the facilities from a company controlled by its own top executive. Paul Doucette, Cornell's spokesman, says the Logan entity is a nonprofit corporation and has no owners.

Charles Elson, director of the Center for Corporate Governance at the University of Delaware, says the potential Logan side deal would be "a conflict-of-interest transaction" because the Cornell "officer is on both sides of the transaction." If executed, such a deal could spark shareholder lawsuits and SEC scrutiny, Mr. Elson says.

Mr. Logan says there are "no plans" to do the deal. He says he formed the new company because "Cornell, in conjunction with its advisers, needed a vehicle to protect its interests in the unlikely event that [Municipal Corrections] could not fulfill its responsibilities." If the deal were done, Mr. Logan says he would resign from the board of the shell company he founded. Since he is currently that board's only director, he would have to appoint one or more replacements.

The fallout from Andersen's questions about the sale-leaseback continued last month, when Cornell restated its financial results for 2000 and the first nine months of 2001. The company, for accounting purposes, moved back to its books the debt and assets that had been transferred to the partnership headed by Provident. But the company said the substance of the sale-leaseback would remain in place: Cornell will rent, not own, the prisons, and it won't reassume its large debt obligations. In the restatement, Cornell also lowered its fourth-quarter 2001 earnings by five cents a share, to 24 cents, before extraordinary charges. But the company said that change was unrelated to the sale-leaseback accounting.

The company in recent months has taken away Mr. Logan's titles as chairman and CEO, although he continues as president. Company board member Harry J. Phillips Jr. is serving as "executive chairman," and there will be no chief executive for now, the company has said.

Milberg Weiss Bershad Hynes & Lerach, the lead plaintiffs' counsel in the shareholder-class-action lawsuits against Andersen and Enron, has filed suit against Cornell on behalf of shareholders. The suit, filed in U.S. district court in Houston, seeks class-action status and accuses Cornell and its officials of making misleading statements about the company's business -- an allegation Cornell denies.

Write to Joseph T. Hallinan at

Updated May 1, 2002