Department of Agriculture failed to execute its own procedures in auditing grain dealers

An audit of the Missouri Department of Agriculture Grain Regulatory Services (GRS) program, specifically focusing on the circumstances of two failed grain dealers, was issued Aug. 5 by Missouri State Auditor Susan Montee. Both licensed grain dealers became insolvent in February 2009; both owners face criminal charges.

According to this 23-page audit report, the GRS program would have detected irregularities sooner at both Gallatin Grain Company and at a Martinsburg dealer if the GRS had executed its own examination procedures better. The scope of this audit excludes particulars which may be relative in criminal investigations; instead, it focuses on methods and means to prevent similar problems of enforcement in the future.

For the complete audit report, go to http://auditor.mo.gov/press/2010-90.htm

In regards to the failed Gallatin Grain Company, the audit says that the GRS…

• Failed to adequately enforce its own procedures; work paper documentation and subsequent supervisor review processes were inadequate.

• GRS confirmations…

      — were not effective in disclosing unrecorded obligations

      — did not require the review of bank deposits made immediately prior to the examination

      — did not require the reconciliation, on a test basis, of the quantities of grain sold on the licensee’s daily position record and individual producer settlements to settlements from the purchasing grain entity (thus allowing grain purchases to be concealed)

      — did not require dealers to utilize pre-numbered contracts, settlement sheets, or receipts for direct farm-to-market transactions (thus allowing dealers to conceal grain obligations)

      — did not accelerate the frequency of examinations as allowed by state law to protect the financial interests of grain producers

• Did not require additional bonding after large negative grain equities became known at Gallatin in April 2008 (about $699,000) and September, 2008 (about $639,000)

• Improperly considered non-grain related assets (much real estate) that were not related to Daniel Froman’s operations as a grain dealer even though state law does not authorize the GRS to take possession of non-grain related assets

Better execution of GRS examination procedures would have reduced producer losses, according to State Auditor Susan Montee. Proper training of GRS personnel is a partial solution.

“Essentially, the GRS offers six months of training and then sends their new employees out in the field,” Auditor Montee said during Thursday’s tele-news conference when the report was released. “My feeling is that these regulators didn’t quite know just how bad this (inefficient regulation) might be.”

The state auditor noted that two more recent grain dealer failures, in southwest Missouri and at Appleton City, were handled much more professionally. Proactive GRS action resulted in no losses to grain producers during these latest failures. The auditor expressed confidence that the Department of Agriculture is doing a much better job of grain dealer regulation today.

Auditor Montee noted that in the past 20 years grain producer losses totaled less than $3 million, none individually considered of major significance when compared to the $32 million failure between the two dealers at Gallatin and Martinsburg.

“The program is set up to protect grain producers but until these large failures hit home, the GRS regulators just preferred to let things work (themselves) out,” Montee said. “The mindset that something really bad could happen just wasn’t there.”

According to the GRS, one of the confirmations sent to a producer during the September 2008 examination of the Gallatin dealer was not returned. The producer was owed more than the reported amount. The GRS has taken action to make producers more aware of the risks by including on the dealer’s license whether the dealer is allowed to enter into credit sales contracts and providing similar information on confirmations sent to producers.

Grain producers suffered losses valued at over $32 million when a Class IV dealer at Martinsburg and the Class I dealer at Gallatin failed. Both became insolvent in February, 2009. The timing, according to Auditor Montee, was mere coincidence.

“The circumstances are completely different,” Montee said. “At Martinsburg the dealer was making deals on credit and offering higher than market prices, then using the dollars to make other payments. This was clearly fraud, and the GRS did not know what was going on.

“Gallatin is different. The financial statements included non-grain assets (real estate) which, clearly, couldn’t be liquidated efficiently to pay claims.

“The dealer reported deficiencies and admitted to millions in losses and then turned over the operation to the state. A number of (GRS) things could have been done better. At Gallatin, a number of problems were always noted in exam reports but the department took no steps to remedy problems.”

State authorities are comparing Missouri’s grain regulatory program and laws to other states. One significant difference is whether the financial statements presented to regulators are audited financial statements.

Missouri’s procedure requires negative confirmation, meaning that a response from the dealer is required only when a particular item is incorrect. Presently, Missouri’s GRS generally assumes that financial reports they receive are accurate. Questions about the accuracy of an item only require a response from the dealer when a particular item is incorrect.

Since the numbers originate from the dealer, numbers are not often questioned. The audit report recommends that Missouri switch to “positive confirmation” where a response is required whether or not the particular item is correct.

“Missouri has no requirement for audited financial statements (from dealers),” says Montee. “Those supplied from failed dealers at both Martinsburg and Gallatin materially misstated their financial standing. From an examination standpoint, it most certainly would have been seen as a problem by any auditor.”

The frequency that audited financial statements are to be presented is also being questioned. Illinois requires audited financial statements from its grain dealers on an annual basis. Iowa requires audited financial statements each month.

The state auditor also points to Missouri’s bonding requirements as “very low.” Minimums for dealer bonds at 1% in most cases and net worth at $10,000 are much lower than required by other states.

“Much of what we recommend does not require legislative action,” says Auditor Montee. “Current law provides a great range for remedies, and the GRS has the ability to do it.”

Written response from the GRS to the audit report’s recommendations generally acknowledges its shortcomings. The audit revealed that even with perfect execution, the procedures the Department has relied on for the past five decades are inadequate to regulate today’s grain dealer and warehousing businesses, and insufficient for early detection of deliberate misrepresentation or criminal misconduct.

According to its written response to the audit report, the GRS “concurs that the financial statements of most licensees are reviewed as opposed to audited, and that if the financial statements of the dealers in question had been audited instead of reviewed, outstanding obligations may have been detected.

“GRS is developing guidelines that require audited financial statements or additional financial information when the circumstances warrant.”

The following is a statement released by Dr. Jon Hagler, Director of the Missouri Department of Agriculture, made in response to the Missouri Auditor report:

“The Missouri Department of Agriculture appreciates the Auditor’s work regarding the processes intended to protect Missouri farmers and grain producers from fraud or warehousing failures. The Department has already implemented improvements to practices that had long been used in the regulation of grain services, and will continue to implement further safeguards.

“Protecting the farmers who are the backbone of Missouri’s agriculture industry is the Department’s top mission. We will use this opportunity to strengthen and reinforce the tools we use to protect our farms and farmers in the future.”