Text II. Lawsuit Bursts Balloon Of Party-goods Chain

After losing its bank line of credit, party-supplies retailer K.G. Marx was hit with an unrelated shareholder lawsuit. Competition from discounters finally drove the company into bankruptcy.

When the party-goods retailer K.G. Marx raised $884,000 in an Ohio-wide public stock-and-bond offering, in the spring of 1995, it seemed that the chain's slogan--"the life of the party"--would be apropos for years to come. The company, based in Waterville, Ohio, near Columbus, unveiled heady plans to expand from five to seven stores in the area, and the future looked "hunky-dory," recalls the founder and former president, Mark L. Frendt.

The good times didn't roll for very long, however. Less than a year later the company's bank withdrew what prior to the public offering had been its only source of short-term funding, a $500,000 line of credit. That ultimately pushed the company into state receivership, offering it the chance to reorganize under court protection from creditors.

But in April 1997 one of the company's shareholders and two of its bondholders dealt K.G. Marx a stunning blow. They filed a lawsuit alleging that the company had neither adequately disclosed its financial condition at the time of the initial public offering nor spent the proceeds as the company had promised in its offering circular. For example, the fact that the company had failed to comply with loan covenants should have been highlighted prominently in the "risk factors" section of the circular rather than buried in a note to the financial statements, says the plaintiffs' attorney, Todd H. Neuman.

The allegations themselves were not unusual. They're typical of the charges that are leveled in the hundreds of shareholder suits brought against U.S. public companies each year. In the vast majority of the cases, however, the dispute is settled, claimants are paid off under the company's insurance policy, and everyone moves forward.

Frendt was not so fortunate. He had founded K.G. Marx as a supplier of food, bulk paper, and janitorial supplies in 1980 but had switched to selling party goods such as paper plates and crepe paper and renting items like china and tents for weddings and other occasions.

By the time of the IPO, sales were closing in on $6 million, and the company had shown a profit for all but two of its years. Money raised in the IPO, as spelled out in the offering circular, was to be used to finance inventory and fixtures for two new stores and to fund a sewer line and laundry facility for the rental division, with the balance going to augment working capital.

How the money actually was spent is in dispute. At least some of it presumably was spent as advertised, because the company did indeed open two new stores. But the plaintiffs allege that Frendt and the three other K.G. Marx directors spent money inappropriately, using some to pay off loans from Bank One Columbus to expunge a lien on Frendt's house. "All allegations in the lawsuit are incorrect," Frendt retorts.

As the company struggled against competition from discounters that opened stores near K.G. Marx's outlets, it lost $227,000 in 1995. With its line of credit gone--Frendt says he still doesn't know why, and Bank One won't comment--there was no way to raise cash for operations. Frendt began liquidating stores, finally closing the last three in mid-July as he entered Chapter 7 bankruptcy.

Now 45-year-old Frendt is out $140,000 in legal and other professional fees, and the litigation against him grinds on. He says he offered to settle before the point of no return was reached but was rebuffed. Neither side will say why. Even if the plaintiffs win, it's unclear whether they will see any money, because unlike most public companies, K.G. Marx didn't have directors' and officers' insurance.

VI. Answer the following questions:

1. What were the causes of company’s ‘death’?

2. What were the grounds for filing a complaint?

3. What were the wrong actions and mistakes of the company’s president?

4. What actions could company undertake to prevent the situation?

5. What will happen if the plaintiffs win?