Fly By night

Fly-By-Night International Group: Can This Company Be Saved? Douglas C. Mather, Founder, Chairman, and Chief Executive of Fly-By-Night International Group (FBN), lived the fast-paced, risk-seeking life that he tried to inject into his Company. Flying the Company’s Learjets, he logged 28 world speed records. Once he throttled a company plane to the top of Mount Everest in 3 1/2 minutes. These activities seemed perfectly appropriate at the time. Mather was a Navy fighter pilot in Vietnam and then flew commercial airlines. In the mid 1970s, he started FBN as a pilot training school. With the defense buildup beginning in the early 1980s, Mather branched out into government contracting. He equipped the Company’s Learjets with radar jammers and other sophisticated electronic devices to mimic enemy aircraft. He then contracted his “rent-an-enemy” fleet to the Navy and Air Force for use in fighter-pilot training. The Pentagon liked the idea and FBN’s revenues grew to $55 million in the fiscal year ending April 30, Year 14.

Its common stock, issued to the public in Year 9 at $8.50 a share, reached a high of $16.50 in mid-Year 13. Mather and FBN received glowing writeups in Business Week and Fortune. In mid-Year 14, however, FBN began a rapid descent. Although still growing rapidly, its cash flow was inadequate to service its debt. According to Mather, he was “just dumbfounded. There was never an inkling of a problem with cash.” In the fall of Year 14, the Board of Directors withdrew the Company’s financial statements for the year ending April 30, Year 14, stating that there appeared to be material misstatements that needed investigation. In December of Year 14, Mather was asked to step aside as manager and director of the Company pending completion of an investigation of certain transactions between Mather and the Company.

On December 29, Year 14, NASDAQ (over-the-counter stock market) discontinued quoting the Company’s common shares. In February, Year 15, the Board of Directors, following its investigation, terminated Mather’s employment and membership on the Board. Exhibits 1 to 3 present the financial statements and related notes of FBN for the five years ending April Year 10 through April Year 14. Exhibits 4 and 5 present selected financial statement ratios. The financial statements for Year 10 to Year 12 use the amounts as originally reported for each year. The amounts reported on the statement of cash flows for Year 10 (for example, the change in accounts receivable) do not precisely reconcile to the amounts on the balance sheet at the beginning and end of the year because certain items classified as relating to continuing operations on the balance sheet at the end of Year 10 were classified as relating to discontinued operations on the balance sheet at the end of Year 10.

The financial statements for Year 13 and Year 14 represent the restated financial statements for those years after the Board of Directors completed its investigation of suspected material misstatements that caused it to withdraw the originally issued financial statements for fiscal Year 14. Exhibit 6 lists the members of the Board of Directors. You are asked to study these financial statements and notes and respond to the following questions: a.What evidence can you observe from analyzing the financial statements that might signal the cash flow problems experienced in mid-Year 14? b.Can FBN avoid bankruptcy during Year 15? What changes in either the design or implementation of FBN’s strategy would you recommend?

Members of the Board of Directors

Charles A. Barry, USAF (Ret.), Executive Vice President of Wicks and Associates, Inc., a management consulting firm Thomas P. Gilkey, Vice President, Marketing
Lawrence G. Hicks, Secretary and General Counsel
Michael S. Holt, Vice President, Finance, and Chief Financial Officer Gordon K. John, Executive Vice President and Chief Operating Officer Douglas C. Mather, Chairman of the Board, President and Chief Executive Officer Edward F. O’Hara, President of the O’Hara Companies, which manufacturers aircraft products E. William Shapiro, Professor of Law, Emory University

NOTES TO FINANCIAL STATEMENTS
1. Summary of Significant Accounting Policies Consolidation
The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries. The Company uses the equity method for subsidiaries not majority owned (50 percent or less) and eliminates significant intercompany transactions and balances. Inventories, which consist of aircraft fuel, spare parts and supplies, appear at lower of FIFO cost or market. Property and equipment appear at acquisition cost. The Company capitalizes major inspections, renewals and improvements, while it expenses replacements, maintenance and repairs that do not improve or extend the life of the respective assets.

The Company computes depreciation of property and equipment using the straight-line method. Contract Income Recognition Contractual specifications (that is, revenue rates, reimbursement terms, functional considerations) vary among contracts; accordingly, the Company recognizes guaranteed contract income (guaranteed revenue less related direct costs) either as it logs flight hours or on a straight-line monthly basis over the contract year, whichever method better reflects the economics of the contract. The Company recognizes income from discretionary hours flown in excess of the minimum guaranteed amount each month as it logs such discretionary hours. Income Taxes The Company recognizes deferred income taxes for temporary differences between financial and tax reporting amounts.

2. Transactions with Major Customers
The Company provides contract flight services to three major customers: the U.S. Air Force, the U.S. Navy, and the Federal Reserve Bank System. These contracts have termination dates in Year 16 or Year 17. Revenues from all government contracts as a percentage of total revenues were as follows: Year 10, 31%; Year 11, 68%; Year 12, 73%; Year 13, 72%; Year 14, 62%.

3. Segment Data During
Year 10, the Company operated in five business segments as follows: Flight Operations – Business Provides combat readiness training to the military and nightly transfer of negotiable instruments for the Federal Reserve Bank System, both under multi-year contracts. Flight Operations – Transport Provides charter transport services to a variety of customers. Fixed Base Operations Provides ground support operations (fuel, maintenance) to commercial airlines at several major airports. Education and Training Provides training for non-military pilots. Aircraft Sales and Leasing Acquires aircraft that the Company then either resells or leases to various firms.

The Company discontinued the Flight Operations – Transport and Education and Training segments in Year 11. It sold most of the assets of the Aircraft Sales and Leasing segment in Year 11.

4.Relation Party Transactions On April 30, Year 11, the Company sold most of the net assets of the Aircraft Sales and Leasing segment to Interlease, Inc., a Georgia corporation wholly owned by the Company’s majority stockholder, whose personal holdings represented at that time approximately 75 percent of the Company.

Under the terms of the sale, the sales price was $1,368,000, of which the buyer paid $368,000 in cash and gave a promissory note for the remaining $1,000,000. The Company treated the proceeds received in excess of the book value of the net assets sold of $712,367 as a capital contribution due to the related party nature of the transaction. FBN originally acquired the assets of the Aircraft Sales and Leasing segment during Year 10.

On September 29, Year 14, the Company’s Board of Directors established a Transaction Committee to examine certain transactions between the Company and Douglas Mather, its Chairman, President and majority stockholder. These transactions appear below: Certain Loans to Mr. Mather In early September, Year 13, the Board of Directors authorized a $1,000,000 loan to Mr. Mather at the Company’s cost of borrowing plus 1/8 percent. On September 19, Year 13, Mr. Mather tendered a $1,000,000 check to the Company in repayment of the loan. On September 22, Year 13, at Mr. Mather’s direction, the Company made an additional $1,000,000 loan to him, the proceeds of which Mather apparently used to cover his check in repayment of the first $1,000,000 loan. The Transaction Committee concluded that the Board of Directors did not authorize the September 22, Year 13 loan to Mr. Mather nor was any director aware of the loan at the time other than Mr. Mather.

The Company’s Year 13 Proxy Statement, dated September 27, Year 13, incorrectly stated that “as of September 19, Year 13, Mr. Mather had repaid the principal amount of his indebtedness to the Company.” Mr. Mather’s $1,000,000 loan remained outstanding until it was cancelled in connection with the ESOP Transaction discussed below. ESOP Transaction On February 28, Year 14, the Company’s Employee Stock Ownership Plan (ESOP) acquired 100,000 shares of the Company’s common stock from Mr. Mather at $14.25 per share. FBN financed the purchase. The ESOP gave the Company a $1,425,000 unsecured demand note. To complete the transaction, the Company cancelled a $1,000,000 promissory note from Mr. Mather and paid the remaining $425,000 in cash. The Transaction Committee determined that the Board of Directors did not authorize the $1,425,000 loan to the ESOP, the cancellation of Mather’s $1,000,000 note, or the payment of $425,000 in cash. Eastwind Transaction On April 27, Year 14, the Company acquired four Eastwind aircraft from a German company.

FBN subsequently sold these aircraft to Transreco, a corporation owned by Douglas Mather, for a profit of $1,600,000. In late September and early October, Transreco sold these four aircraft at a profit of $780,000 to unaffiliated third parties. The Transactions Committee determined that none of the officers or directors of the Company were aware of the Eastwind transaction until late September, Year 14. On December 12, Year 14, the Company announced that Mr. Mather had agreed to step aside as Chairman and a Director and take no part in the management of the Company pending resolution of the matters presented to the Board by the Transactions Committee.

On February 13, Year 15, the Company announced that it had entered into a settlement agreement with Mr. Mather and Transreco resolving certain of the issues addressed by the Transactions Committee. Pursuant to the agreement, the Company will receive $211,000, the bonus paid to Mr. Mather for fiscal Year 14, and $780,000, the gain recognized by Transreco on the sale of the Eastwind aircraft. Also pursuant to the settlement, Mr. Mather will resign all positions with the Company and waive his rights under his employment agreement to any future compensation or benefits to which he might otherwise have a claim.

6.Market Price Information The Company’s common stock trades on the NASDAQ National Market System under the symbol FBN. Trading in the Company common stock commenced on January 10, Year 10.