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The following is an excerpt from a 10-K SEC Filing, filed by SPURLOCK INDUSTRIES INC on 4/17/1998.
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SPURLOCK INDUSTRIES INC - 10-K - 19980417 - LEGAL_PROCEEDINGS

Item 3. Legal Proceedings

Summary

In late January and early February 1998, the Company discovered that two of its officers and directors, Irvine R. Spurlock and H. Norman Spurlock, Jr., had diverted corporate funds for personal use and that, according to a report of a Special Litigation Committee of the Company's Board of Directors, a third officer, Warren E. Beam, had colluded in the diversions by Norman Spurlock. Following these discoveries, Norman Spurlock and Mr. Beam resigned as officers and employees of the Company and Spurlock Adhesives and Norman Spurlock also resigned as a director of both companies. Irvine Spurlock resigned as Chairman of the Board, Chief Executive Officer and a director of both the Company and Spurlock Adhesives, but was retained by the Board of Directors with the title of President of both companies because of his current importance to their operations, but without any check writing or other financial authority. Irvine Spurlock made restitution for his defalcation, and, effective April 8, 1998, Norman Spurlock entered into a settlement agreement to make restitution for his defalcation. An investigation by the Special Litigation Committee and the Company's new independent accounting firm concluded that no other officers or directors of either the Company or Spurlock Adhesives were involved in the defalcations.

Shareholders' Derivative Suit

On April 28, 1997, seven shareholders of the Company filed a shareholders' derivative suit against the Company and certain current and former officers and directors of the Company in Colorado state court. The lawsuit was subsequently removed to the United States District Court for the District of Colorado (the "District Court"). The Company has previously disclosed the lawsuit to the Securities and Exchange Commission (the "Commission") in the Company's Quarterly Report on Form 10-Q for the period ended June 30, 1997.

The shareholders' derivative suit, Rasmussen et al. v. Spurlock Industries, Inc., et al. (Civil Action No. 97-D-2214), alleges that the defendants named therein engaged in various activities that breached their fiduciary duties to the plaintiffs and/or violated provisions of Colorado law applicable to domestic corporations. The activities so alleged include wrongful payment and wrongful guarantee of debts of one or more defendants, unlawful loans and distributions to defendants, unfair dealings with one or more defendants, overcompensation of defendants and other employees, wrongful depression of the Company's stock price, misrepresentation as to shareholders, and improper approval of the merger of Air Resources Corporation (the Company's predecessor) into the Company. The plaintiffs seek a declaratory judgment with respect to the acts complained of, repayment of certain monies to the Company, an accounting of all financial transactions of the Company from 1992 to the present, a constructive trust of shares of common stock held by certain defendants, injunctive relief and damages.

In May 1997, the Company's Board of Directors, in response to the lawsuit, appointed a Special Litigation Committee to investigate the allegations and to determine whether maintenance of the derivative proceeding was in the best interests of the Company. The members of the Special Litigation

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Committee are Raymond G. Tuttle and Glen S. Whitwer, the Company's two outside directors, neither of whom is named as a defendant in the lawsuit nor was a member of the Board of Directors during the time period of the activities alleged in the lawsuit. The Special Litigation Committee engaged independent outside counsel to advise it in its investigation, and performed an extensive investigation including the collection and review of a large number of relevant corporate and related documents, and interviews of current and former officers and directors, the Company's independent auditor and its outside legal counsel. In a report delivered to the District Court in October 1997, the Special Litigation Committee determined that maintenance of the lawsuit was not in the best interests of the Company. Based on the findings of the Special Litigation Committee, the Company filed a Motion for Summary Judgment against the plaintiffs on November 12, 1997.

As a result of the events summarized under "Summary" above and more particularly described below, on February 9, 1998 and March 26, 1998, the Special Litigation Committee requested that the District Court delay ruling on the Motion for Summary Judgment to allow the Special Litigation Committee to investigate the facts surrounding these events. The Special Litigation Committee filed a supplemental report with the District Court on April 13, 1998 (the "SLC Supplement"), and the Motion for Summary Judgment remains pending.

Creation of Audit Committee

In November 1997, at the request of the Special Litigation Committee, the Board of Directors created an Audit Committee, which consists of Messrs. Tuttle and Whitwer. The initial responsibility of the Audit Committee was to identify a new auditor for the Company. The Company wished to appoint a new auditor primarily because the auditor at that time, James E. Scheifley & Associates, P.C. (formerly Winter, Scheifley & Associates, P.C.) ("Scheifley"), was located in Colorado and recently had one of its two partners leave its practice. As the Audit Committee considered proposals from other firms, Mr. Whitwer asked Phillip S. Sumpter, then Executive Vice President and Chief Financial Officer of the Company, to request that Scheifley examine, in the course of the audit of the 1997 fiscal year, insider transactions, and specifically loans to officers, to ensure that such loans were current.

Discovery of Diversion of Corporate Funds by Officers and Directors

On January 9, 1998, Catharine Spurlock, the Company's Administrative Assistant and wife of Irvine Spurlock, then Chairman of the Board of Directors, President and Chief Executive Officer of the Company, addressed Irvine Spurlock with concerns over unusually high charges on the Company's credit card by Norman Spurlock, then Executive Vice President and Secretary of the Company. Irvine Spurlock consulted with Mr. Sumpter, who examined the credit card records and concluded that these charges were a problem. When confronted, Norman Spurlock admitted to charging personal expenses on the Company's credit card over the previous two months. Norman Spurlock also revealed that he was in default on an authorized loan with the Company and asserted that he was pursuing a home equity loan in order to make restitution for both the unauthorized personal expenses and the outstanding loan payments.

On January 14, 1998, Scheifley began the 1997 audit at the Company's principal executive offices. Scheifley met with Mr. Sumpter to discuss the issues surrounding Norman Spurlock's loan default, but did not receive notice of any concerns regarding unauthorized credit card transactions by Norman Spurlock, and was unable to procure certain information requested of Warren Beam, Controller, with respect to charges on one of the Company's primary corporate credit cards. Scheifley did not identify any additional problems.

On January 21, 1998, Mr. Whitwer met with Irvine Spurlock, Mr. Sumpter and the Company's corporate legal counsel to discuss what actions the Board of Directors should take with respect to Norman Spurlock, and the implications for the Special Litigation Committee's report. It was decided that, before such decisions could be made, Mr. Sumpter would review records to ensure an understanding of the status of officer loans to Norman Spurlock. Mr. Whitwer expressed the opinion that it would be necessary to conduct a special audit of officer loans and officer expenses to ensure that the Company reached the bottom of the problem.

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On January 22, 1998, Mr. Sumpter discovered $11,000 of unauthorized advances to Norman Spurlock in 1996 and additional advances in 1995. When confronted with these findings on January 23, 1998, Norman Spurlock admitted to the unauthorized advances and, at the demand of Harold Spurlock, Sr., a director and the founder of the Company and the father of Irvine Spurlock and Norman Spurlock, resigned as an officer, director and employee of the Company and Spurlock Adhesives. Further internal investigations by Mr. Sumpter uncovered, in addition to the unauthorized advances and loan defaults, substantial credit card abuse by Norman Spurlock, with a total defalcation estimated at $150,000.

In light of the discoveries involving Norman Spurlock, Warren Beam resigned as Controller-Treasurer of the Company and Spurlock Adhesives on January 26, 1998. As set forth in the SLC Supplement, the Special Litigation Committee investigation indicated that, while there was no evidence that Mr. Beam personally received any of the diverted funds, Mr. Beam had colluded with Norman Spurlock.

By February 5, 1998, the Audit Committee had engaged Cherry, Bekaert & Holland, L.L.P. ("Cherry, Bekaert") to conduct a full investigation of all officer salaries, perquisites, loans and advances and to assess the impact of any and all misuse of the Company's funds. In addition, the Company determined to request a postponement in the District Court's ruling on the Motion for Summary Judgment in order that the Special Litigation Committee could investigate the newly discovered information and supplement its previous report, as necessary.

On February 8, 1998, after Cherry, Bekaert's investigation had commenced, Irvine Spurlock, through his counsel, disclosed to the Company's outside legal counsel that he had received two unauthorized advances in the amounts of $42,500 and $9,200, both of which had been fully repaid, and an additional unauthorized advance in the amount of $73,075.86, which had not been repaid. Upon this admission, Irvine Spurlock provided the Company with a check in the amount of $73,075.86 and offered to resign if requested to do so. On February 9, 1998, Irvine Spurlock disclosed further to Mr. Sumpter that he had made personal charges on the Company's credit card in an estimated amount of $7,000 to $8,000.

The Board of Directors met on February 11, 1998 to take action on the information that had been uncovered to date, including recent disclosures by Irvine Spurlock. At the meeting, the Board of Directors asked Irvine Spurlock to resign as Chairman and a member of the Board of Directors and as Chief Executive Officer of both the Company and Spurlock Adhesives. Following the tendering of these resignations, the Board of Directors elected Mr. Sumpter to replace Irvine Spurlock as Chairman of the Board and Chief Executive Officer of the Company and Spurlock Adhesives.

The Board of Directors decided, nevertheless, to retain Irvine Spurlock with the title of President of both the Company and Spurlock Adhesives. In reaching such a decision, the Board of Directors weighed the gravity of his actions against the possible impact to the Company of his departure. Among other considerations, the Board of Directors acknowledged the importance of Irvine Spurlock's role in the critical area of purchasing of raw materials used in the Company's production process, his long-standing relationships with the Company's customers and lenders, and his extensive background in the Company's manufacturing operations where he acts as the Company's final technical authority. The Board also took into account the strain placed on remaining management by the recent resignations of two other executive officers, given the Company's small executive staff. The Board of Directors concluded that, due to the skills provided by Irvine Spurlock, his departure at that time could result in substantial adverse consequences to the Company. In connection with his retention, however, the Board of Directors revoked all of his check-signing and related financial authority.

Conclusion of Investigation

On February 17, 1998, the Board of Directors approved the replacement of Scheifley as the independent accountant chosen to audit the Company's financial statements and approved the appointment of Cherry, Bekaert as the Company's independent accountant for the 1997 fiscal year. The

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Company has previously disclosed the appointment to the Commission on a Current Report on Form 8-K dated February 17, 1998. Cherry, Bekaert is the largest regional CPA firm in the southeast, with over 300 people in 23 offices. It is headquartered in Richmond, Virginia.

By the end of February 1998, Cherry, Bekaert had concluded much of the investigation of management-related defalcations, and, by March 18, 1998, had completed most follow-up tasks in conjunction with the 1997 audit of the Company. Having performed investigatory procedures on relevant available records from August 1992 through January 1998, Cherry, Bekaert found diversion of funds in two areas - unauthorized advances and personal credit card charges paid by the Company. The following table presents the results of Cherry, Bekaert's investigation, net of all repayments through January 1998, by the named individuals, excluding accrued interest:

                           Unauthorized       Personal Charges to
Officer/Director             Advances              Credit Card              Total
----------------             --------              -----------              -----

Irvine R. Spurlock          $  73,075.86          $    8,176.03          $  81,251.89

H. Norman Spurlock, Jr.     $ 112,401.78          $  154,779.37          $ 267,181.15

Advances and loans to Harold N. Spurlock, Sr. and Irvine Spurlock were also evaluated. Nothing was noted that required additional investigation. Cherry, Bekaert found no evidence that either Mr. Sumpter or Harold Spurlock or any corporate officer or director other than Norman Spurlock, Irvine Spurlock or Warren Beam was involved in any misuse of the Company's funds.

The SLC Supplement reported that Cherry, Bekaert's investigation had revealed that the diversion of corporate funds was concealed by the falsification of records and collusion and that the discovery of such diversion by the Company's auditors and management would have been difficult. Further, the SLC Supplement reported that the unauthorized advances to Norman Spurlock were hidden by false workpapers prepared by Mr. Beam and furnished to Scheifley, as well as the collusion of Norman Spurlock and Mr. Beam. Pursuant to Cherry, Bekaert's investigation, these workpapers presented only those loans to officers that had been approved by the Board of Directors, together with a complex series of entries indicating that such loans were being repaid, when, in fact, they were not.

According to the SLC Supplement, with respect to the personal charges on the Company's credit card, Norman Spurlock was the officer who approved travel and entertainment expenses for all employees. Cherry, Bekaert discovered that these charges were allocated to various expense accounts in different cost centers, at Norman Spurlock's direction, by Catharine Spurlock, who issued the checks for approved expenses. Cherry, Bekaert believes that Catharine Spurlock did not see the details of the credit card bills, which were allocated over many general ledger accounts. Mr. Beam was the individual ultimately responsible for posting these expenses. Based on Cherry, Bekaert's investigation, the Special Litigation Committee could not confirm whether or not Mr. Beam was aware of Norman Spurlock's credit card abuse, but it appeared that the combination of the amounts involved and the wide array of ledger accounts should have led to Mr. Beam's discovery of these abuses. According to the SLC Supplement, Mr. Beam colluded with Norman Spurlock in the diversion of corporate funds, but there was no indication that Mr. Beam personally received any such funds.

Furthermore, the SLC Supplement concluded, based on Cherry, Bekaert's investigation, that Irvine Spurlock diverted corporate funds by having the Company purchase boat motors and charging the amounts to another capital item of the Company (forklifts). Catharine Spurlock issued two of the three checks involved, totaling $25,000. While the Special Litigation Committee found indications that she knew what the checks were for, as the payee was not a vendor of the Company, Cherry, Bekaert found no evidence of any further wrongdoing by Catharine Spurlock. Ms. Spurlock was relieved of any check writing and related financial authority, and is being reassigned from the Company's corporate offices to a non-financial administrative assistant position in Spurlock Adhesives' manufacturing plant, located in

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Waverly, Virginia. According to the SLC Supplement, the personal charges to the Company's credit card by Irvine Spurlock, amounting to approximately $8,200, were in numerous travel and entertainment accounts.

Restitution by Officers and Directors

Upon disclosing on February 8, 1998 the unauthorized advances paid to him, Irvine Spurlock paid the Company $73,075.86 as restitution. By March 18, 1998, Irvine Spurlock had paid $28,867.83 as additional restitution for the $8,176.03 in personal charges to the Company's credit card, and interest at the Company's borrowing rate accrued on the unauthorized advances and personal charges. Irvine Spurlock also provided an additional $1,000 to help defray a portion of the estimated legal expenses incurred by the Company.

The Special Litigation Committee was informed, however, that Norman Spurlock probably was financially incapable of making immediate full restitution. In a settlement between the Company and Norman Spurlock, dated April 8, 1998, Norman Spurlock agreed to restitution of $385,000, $10,000 of which has been repaid to Spurlock Adhesives. As a part of such settlement, Spurlock Family Partnership, which holds the shares of the Company's common stock owned by Harold, Irvine and Norman Spurlock, has delivered a promissory note for $375,000, approximately $50,000 of which represents legal and auditing costs associated with the investigation. Payments on the promissory note of interest only are due monthly, at 9% per annum, for three years with a balloon payment for the full amount at the end of the three years. The promissory note is secured by 2,325,000 unencumbered shares of common stock of the Company held by the Partnership and is personally guaranteed by Harold Spurlock. Norman Spurlock has also confessed judgment for $375,000 docketed in the Circuit Court of Sussex County, Virginia, which, under the terms of the settlement, will not be enforced or domesticated in other jurisdictions by Spurlock Adhesives so long as the promissory note is paid as agreed.

In response to the events described above, the Audit Committee and the Company have taken immediate action to strengthen the Company's internal accounting controls. Immediately following the discovery of the diversion of corporate funds, the Company obtained the resignations of the two officers (Norman Spurlock and Warren Beam) and the two directors (Norman Spurlock and Irvine Spurlock) involved in such diversion. In addition, all expense reports, including both reimbursements for expenses and employee advances of salary, were submitted to Mr. Sumpter for approval. Furthermore, the Company has prepared and implemented formal procedures with respect to the review and approval of travel and related expense reimbursement requests. Specifically, all such requests are now forwarded to Lawrence C. Birkholz, the Company's Controller, for review and then to Mr. Sumpter for approval. In addition, no advances may be made to any officers of the Company without satisfactory business justification. Finally, the Company has changed and limited the signatories on its checking accounts.

Supplemental Report of Special Litigation Committee

On April 13, 1998, the Special Litigation Committee filed with the District Court a supplement to the report that it had filed in October 1997. The SLC Supplement presented to the District Court the conclusions of the Special Litigation Committee as to whether or not maintenance of the shareholders' derivative suit is in the best interests of the Company in light of the events described above. First, the Committee stated that the SLC Supplement addressed only Claim Three of the plaintiffs' complaint, which generally alleged unauthorized loans to directors and officers. The Committee reiterated its conclusions and recommendations regarding all claims other than Claim Three stated in its original report, i.e., that pursuit of such claims would not be in the best interests of the shareholders of the Company.

Second, the Special Litigation Committee concluded that pursuit of Claim Three was not in the best interests of the Company given that (i) the Company has received restitution from Irvine Spurlock and a legally binding restitution agreement from Norman Spurlock, (ii) the Company immediately implemented major changes in management, including the resignations of two officers (Norman Spurlock

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and Warren Beam) and two directors (Norman Spurlock and Irvine Spurlock) involved in the diversion of corporate funds, and (iii) the Company has implemented changes in internal controls to guard against future diversion of corporate funds. The Special Litigation Committee further identified certain risks to the Company if the shareholders' derivative suit were maintained. As a small company with limited resources, the Company is subject to a high level of scrutiny by, for example, prospective business partners and lenders and could experience loss of corporate opportunities. In addition to these risks identified by the Special Litigation Committee, management believes that continuation of the lawsuit would result in the Company's incurrence of additional legal and related expenses, which could adversely affect the profitability of the Company, and would provide distractions to management's day-to-day operations of the Company.

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