oversight

Magnolia Lane Apartments, Project Management Operations, Conway, South Carolina

Published by the Department of Housing and Urban Development, Office of Inspector General on 2002-06-05.

Below is a raw (and likely hideous) rendition of the original report. (PDF)

             MAGNOLIA LANE APARTMENTS
           PROJECT MANAGEMENT OPERATIONS
               CONWAY, SOUTH CAROLINA


                           2002-AT-1001
                           JUNE 5, 2002


                           OFFICE OF AUDIT
                     SOUTHEAST/CARIBBEAN REGION




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                                                              Issue Date
                                                                      June 5, 2002
                                                              Audit Case Number
                                                                      2002-AT-1001




  TO:            Glenda L. Fesperman, Acting Director, Columbia Multifamily Program
                   Center, 4EHM


  FROM:          Nancy H. Cooper
                 Regional Inspector General for Audit-Southeast/Caribbean, 4AGA


  SUBJECT:       Magnolia Lane Apartments
                 Project Management Operations
                 Conway, South Carolina

  We completed an audit of Magnolia Lane Apartments, Conway, South Carolina. We conducted
  the audit pursuant to a request by your office. This report contains two findings that require
  follow-up action by your office to implement appropriate corrective action.

  You have completed final action on recommendation No. 1A. Within 60 days please provide us,
  for recommendations 1B and 1C in this report, a status report on: (1) the corrective action taken;
  (2) the proposed corrective action and the date to be completed; or (3) why action is considered
  unnecessary. Also, please furnish us copies of any correspondence or directives issued because
  of the audit.

  Should you or your staff have questions, please contact Terry A. Cover, Assistant Regional
  Inspector General for Audit, or Senior Auditor, Narcell Stamps, at (404) 331-3369.




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   Executive Summary
   We conducted the audit of Magnolia Lane Apartments in response to a request by the
   Department of Housing and Urban Development (HUD), Columbia State Office, Multifamily
   Program Center. We reviewed certain aspects of project operations for compliance with HUD
   requirements. Specifically, the audit objective was to determine if the mortgagor used project-
   operating funds in compliance with the Regulatory Agreement and HUD requirements
   specifically related to the distributions of earnings. We did not audit project construction
   activities and costs.

   The owner/manager of Magnolia Lane misused project operating and trust funds, and
   encumbered project assets in violation of its Regulatory Agreement. Although funds were
   available for at least six mortgage payments, the owner made no payments, causing the mortgage
   default and subsequent assignment to HUD. Throughout the period of default, the owner ignored
   HUD’s repeated requests for monthly accounting reports it needed to monitor project revenues
   and disbursements. Also, the owner did not remit net project cash (funds remaining after
   payment operating expenses) to HUD’s lock box as HUD requested.

   The owner disbursed $185,129 in project operating and trust funds for ineligible distributions
   ($166,364), unreasonable and unnecessary costs ($15,558), and unsupported costs ($3,207.) The
   distributions included $148,625 paid after the mortgage default, constituting an equity skimming
   violation. The owner directly benefited from $82,434 of the ineligible disbursements. The
   owner improperly encumbered a project escrow account for $100,000 to secure unspecified
   notes, and spent $43,225 in tenant security deposits and prepaid rent which were required to be
   held in trust accounts to cover the corresponding project liabilities. We attribute these conditions
   to the owner’s failure to abide by HUD requirements specified in the Regulatory Agreement that
   he signed.

   We recommend that your office obtain mortgagee-in-possession (action completed) to secure
   and protect HUD’s interest in this project. We further recommend that your office debar the
   mortgagor and its individual principals from future participation in HUD programs; require the
   owner to reimburse the project operating and trust accounts for $166,364 of ineligible
   disbursements and $15,558 of costs found to be unreasonable and unnecessary; and require
   adequate documentary support, or reimbursement, for $3,207 of unsupported costs.

   We discussed the violations with the owner during the audit and at an exit conference on
   April 25, 2002. The owner provided written responses to the draft report on May 9, 2002. The
   owner disagreed with certain conclusions reached in finding 1 but he basically agreed with
   finding 2. The owner’s written comments, minus the lengthy exhibits, are presented in Appendix
   D. We considered the owner’s response in finalizing the report. The owner’s comments are
   summarized within each finding. We will provide the owner’s comments with exhibits to your
   office under separate cover.




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   Table of Contents

   Management Memorandum                                                 i


   Executive Summary                                                   iii


   Introduction                                                         1


   Findings

   1    Mismanagement of Project Funds and Assets Contributed to
        Mortgage Default and Assignment                                 3


   2    Misuse of Security Deposits and Prepaid Rent                  13



   Management Controls                                                15


   Follow-Up On Prior Audits                                          17



   Issue Needing Further Study and Consideration                      19



   Appendices
        A Summary of Questioned Costs                                 21

        B Schedule of Ineligible Distributions                        23

        C Schedule of Unreasonable and Unsupported Costs              25

        D Auditee Comments                                            27

        E Distribution                                                29

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   Abbreviations

   HUD            United States Department of Housing and Urban Development




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   Introduction
   Background

   Magnolia Lane Apartments, located in Conway, South Carolina, is a 48-unit profit motivated
   project owned by Magnolia Lane Inc, (Mortgagor). HUD authorized and financed the project
   under section 221(d)(4) of the National Housing Act. The stockholders in the mortgagor entity
   were James C. Hicks, President (48 percent); Margaret L. Hester, Vice President (48 percent);
   and Superior Construction Greenville LLC, general contractor (4 percent). Ms. Hester and Mr.
   Hicks are sister and brother. Mr. Hicks (herein referred to as “owner”) managed, controlled, and
   directed all aspects of the project and maintained the project’s books and records.

   On November 2, 2000, the owner signed the substantial completion certificate for this newly
   built project. However, after signing the certificate, he questioned the adequacy and
   completeness of the general contractor’s work and refused to pay the contract retainage. On
   January 29, 2002, the general contractor filed suit against the mortgagor seeking payment and
   damages. We did not audit these issues since they were known to HUD and were being
   reviewed by HUD’s Columbia State Office staff.

   The owner made no mortgage payments from project operating revenues and allowed the
   mortgage to go into default on April 1, 2001. The lender paid the only payments made on the
   mortgage. For February and March 2001, the lender paid mortgage payments from the project’s
   operating deficit and working capital reserve account. The lender filed an assignment of the
   mortgage to HUD on July 10, 2001. HUD provided the mortgagor with an opportunity to submit
   a workout plan to bring the mortgage current. The mortgagor submitted a work out plan, but
   HUD rejected it because it did not meet requirements. As a result, the Columbia State Office
   recommended foreclosure on the mortgage. Subsequently, HUD’s Headquarters’ Office decided
   to sell the project in the upcoming July 2002 note sale versus foreclosure.

   While the audit was in process, the Columbia State Office referred the mortgagor to HUD’s
   Enforcement Center, issued limited denials of participation against the owner and his sister
   (co-owner), and initiated steps to debar them. Also during the audit, the HUD Office of General
   Counsel, working with the Enforcement Center, contacted the owner and demanded that he turn
   over control of the project to HUD. Immediately following the April 25, 2002, exit conference
   HUD’s staff again met with the owner and his attorney concerning the mortgagee in possession
   agreement. The owner signed HUD’s mortgagee in possession agreement on April 25, 2002,
   granting HUD control of the project. HUD’s contract manager arrived on site on April 26, 2002,
   to take physical control of the project and assumed management of project operations.




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   Introduction


                           The audit objective was to determine if the mortgagor used
    Audit objectives and   project-operating funds in compliance with the Regulatory
    scope                  Agreement and HUD requirements specifically related to
                           the distributions of earnings.     We did not audit project
                           construction activities and costs.

                           To accomplish the objective, we reviewed project records
                           at HUD’s Columbia, South Carolina, office and at the
                           office of an attorney representing the owner/manager of
                           Magnolia Lane Apartments in Conway, South Carolina.
                           The owner/manager arranged for us to review project
                           records at the attorney’s office. We also interviewed
                           officials at HUD’s Columbia and Atlanta offices, the
                           owner/manager, the owner’s attorney, and four tenants.

                           The audit covered the period December 1, 2000, through
                           December 15, 2001. During this period, the project
                           disbursed $244,194 from its operating account. We
                           reviewed $201,603, or 83 percent of the disbursements.
                           We selected and reviewed disbursements based on the
                           dollar amount and the type or name of the payee. We
                           conducted the audit from December 2001 through March
                           2002 in accordance with generally accepted government
                           auditing standards.




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                                                                                          Finding 1


      Mismanagement of Project Funds and Assets
         Contributed to Mortgage Default and
                     Assignment
   Magnolia’s managing owner improperly disbursed $185,129 in project operating and trust funds,
   while not making mortgage payments and ignoring HUD’s requests for monthly accounting
   reports. The questioned disbursements consisted of $166,364 for ineligible distributions,
   $15,558 for unreasonable costs, and $3,207 for unsupported costs. The ineligible distributions
   included $148,625 disbursed after mortgage default and $108,162 after HUD specifically warned
   the owner about improper distributions. The owner also encumbered project assets for $100,000
   to secure unspecified notes. The misuse of funds contributed to the mortgage default and HUD’s
   recommendation to foreclose on the mortgage. We attribute these conditions to the owner’s
   failure to abide by HUD requirements.


                                       At HUD’s request, the owner shall furnish monthly
    Owner not                          occupancy reports and shall give specific answers to
    responsive to HUD                  questions upon which information is desired from time to
                                       time relative to income, assets, liabilities, contracts,
                                       operations, conditions of the property, and the status of the
                                       insured mortgage (Regulatory Agreement Section 9(f)).
                                       HUD provided the owner with the form ”Monthly Report
                                       for Establishing Net Income” used to prepare monthly
                                       reports. The form provided for detailed reporting of project
                                       cash balances, disbursements, and accounts payable.

                                       The owner did not comply with HUD’s repeated requests
                                       for monthly accounting reports and to HUD’s request to
                                       remit net cash, after payment of operating costs, to HUD’s
                                       lock box. The owner’s noncompliance was significant
                                       considering that he made no mortgage payments and used
                                       project funds for unauthorized purposes. HUD made the
                                       following requests for monthly accounting reports and
                                       remittance of project net cash:

                                                             Type          Nature of HUD’s
                                               Date          Request       Request

                                       March 12, 2001           Letter     Monthly Accounting
                                                                           Report
                                       May 22, 2001             Letter     Monthly Accounting
                                                                           Report

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   Finding 1

                     July 18, 2001            Letter     Monthly Accounting
                                                         Report
                     July 18, 2001            Letter     Remit net cash (cash
                                                         remaining after
                                                         payment of costs for
                                                         operations and
                                                         maintenance) to HUD’s
                                                         lock box.
                      September 6, 2001      Meeting     Monthly Accounting
                                                         Report

                     The owner did provide HUD with limited financial
                     information (balance sheet and operating statements)
                     during a September 6, 2001, meeting. However, the owner
                     never provided the requested monthly reports. This
                     violation deprived HUD of the financial information it
                     needed to monitor project revenues, disbursements and
                     obligations.

                     Near the completion of the audit, the owner also became
                     unresponsive to our requests for information. The owner
                     initially cooperated and provided information we requested
                     for the audit. However, as we prepared to finalize on-site
                     audit work, the owner did not respond to our written
                     request and repeated telephone calls to schedule a final visit
                     to update financial information through January 31, 2002.
                     We terminated on-site work without obtaining updated
                     financial data. We decided to report our findings based on
                     the information through December 15, 2001, rather than
                     delay the report while seeking additional records via legal
                     enforcement processes.


                     Distributions means any withdrawal or taking of project
    Ineligible       cash or any assets of the project including the segregation
    distributions    of cash for subsequent withdrawal, excluding payments for
                     reasonable expenses incidental to the operations and
                     maintenance of the project (Regulatory Agreement, Section
                     13(g)). Without HUD’s prior written permission, owners
                     shall not make or receive and retain any distribution of
                     assets or any income of any kind of the project except
                     surplus cash. Owners shall not make distributions from
                     borrowed funds, prior to completion of the project, or when



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                                                                              Finding 1

                          there is any default under the Regulatory Agreement or
                          under the note or mortgage (Regulatory Agreement,
                          Section 6(e)). Any owner receiving such funds in violation
                          of the Regulatory Agreement shall hold such funds in trust
                          (Regulatory Agreement, Section 9(g)).

                          The owner disbursed $166,364 from project operating
                          funds for ineligible distributions, including $82,434 that
                          directly benefited the owner. Appendix B provides a
                          detailed listing of the expenditures summarized below:

                                                     Characteristics of the Distributions
                     Description                      Portion      Portion
                           of                          After        After      Amount
                     Distributions    Improper       Mortgage Written Benefiting
                                     Distribution     Default     Warning       Owner

                     Transfers to
                     Money
                     Market
                     Account               $53,000   $ 53,000 $ 53,000          $19, 832
                     Payments To
                     or For Owner           38,828      32,886      15,103        38,828
                     Washers and
                     Dryers                 29,337      23,247      17,052             0
                     Repayment
                     of Loans               20,589      19,389      11,247        20,589
                     Legal Fees             13,501      12,301       9,411             0
                     Other                  11,109       7,802       2,349         3,185

                     Totals               $166,364   $148,625    $108,162       $ 82,434

                              Transfers to Money Market Account - The owner
                              transferred $53,000 from the operating account to a
                              money market account maintained in the name of the
                              mortgagor entity, Magnolia Lane, Inc. The owner
                              subsequently disbursed $19,832 to an identity-of-
                              interest firm, H&H Investments as partial payment on
                              four loans totaling $53,154, which the owner recorded
                              on the project books. The owner stated that he also
                              owned H&H Investments and that the loans resulted
                              from amounts H&H paid for project contractor fees and
                              construction costs. The loans were subordinate to the
                              defaulted mortgage. The owner also disbursed $15,000
                              for a legal retainer fee in a suit against the general

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   Finding 1

                     contractor. The legal fee was a mortgagor expense
                     versus an expense incident to the operation and
                     maintenance of the project. As of December 15, 2001,
                     the owner had not spent the remaining $18,299
                     (including interest).

                     The construction cost ($53,154) H&H paid with
                     proceeds from the four loans were not included in the
                     independent public accountants report of the mortgagor
                     actual cost to construct Magnolia Lane. The owner
                     recorded the $53,154 cost and loans between January 2
                     and 4, 2001, by debits to the building asset account and
                     credits to notes payable. The transactions occurred the
                     week after the independent public accountant’s
                     December 31, 2000, audit cut-off date. The costs, if
                     related to construction, should have been included in
                     the independent public accountant’s certified costs.

                     The owner’s written response to the finding did not list
                     and specify the costs H&H paid for construction. We
                     did not pursue the issue because even if the
                     expenditures were for legitimate construction costs the
                     owner was prohibited from using operating funds to pay
                     for them.

                     Payments To or For Owner - The $38,828 included
                     $18,178 for excessive and ineligible 2001 management
                     fees, $18,900 for ineligible management fees attributed
                     to the prior year (2000), $1,335 for a duplicate
                     payment, and $415 for owner medical expenses.

                     The excessive 2001 management fee exceeded the
                     allowed fee based on the five percent fee rate stipulated
                     in the management certification the owner executed
                     with HUD. The owner claimed that he earned the 2000
                     fee due to the extraordinary time spent dealing with
                     construction problems. The owner received separate
                     compensation for managing construction through the
                     $267,724 profit and risk allowance paid from mortgage
                     proceeds and included in the project’s certified
                     construction cost. The duplicate payment was for a cost
                     the owner paid from project funds to a vendor (check
                     number 1242) and subsequently reimbursed himself for
                     the same cost by check number 1298.


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                                                                        Finding 1

                        Washers and Dryers - The $29,337 required HUD’s
                        approval as a capital purchase. HUD staff stated they
                        did not authorize the owner to use project-operating
                        funds to purchase the units.

                        Repayment of Loans - The $20,589 was for payments
                        on a $50,000 personal note the owner obtained from a
                        local bank on January 12, 2001. The owner did not
                        deposit the loan proceeds to the project’s operating
                        account and we did not determine what the owner did
                        with the funds. The loan payments were not related to
                        project operations and they were subordinate to the
                        defaulted mortgage.

                        Legal fees - The $13,501 was for legal fees related to
                        construction issues between the mortgagor entity and
                        contractor. These costs do not qualify as project
                        operation and maintenance expenses.

                        Other - The $11,109 was for various costs attributed to
                        construction or the mortgagor entity versus expenses
                        for project operations and maintenance. The payments
                        included $5,789 for construction work and an extension
                        fee, $2,309 for non-mortgage interest, $2,135 for office
                        furnishings, and $876 for cash transferred to bank
                        accounts of the mortgagor and an affiliate, H&H
                        Investment Inc.

                     The above distributions violated the project Regulatory
                     Agreement and are subject to the double damages remedy
                     for unauthorized use of multifamily housing project assets
                     and income (12 USC 1715z-4). The $148,425 paid after
                     mortgage default is subject to remedy under the equity
                     skimming statute (12 USC 1715z-19). The distributions
                     included $108,162 disbursed after a HUD letter dated July
                     18, 2001, specifically warned the owner about using project
                     funds for improper purposes. The letter stated that until the
                     mortgage was current, you are prohibited from taking any
                     owner distributions, repaying any funds advanced to the
                     project, or repaying either interest or principal on any
                     project obligation junior to the HUD mortgage. The letter
                     cited the Federal Statutes related to equity skimming and
                     double damages.



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   Finding 1

                        We interviewed the owner and his attorney to determine
                        why the owner continued to make improper distributions
                        after receiving the HUD notice. The owner claimed that he
                        did not receive the notice. HUD’s files show that it sent the
                        letter to the owner by certified mail at two different
                        addresses. The owner signed certified receipts for the both
                        copies of the letter, one on July 23, and the other on July
                        27, 2001.


                        The owner executed a Management Certification with
    Unreasonable and    HUD whereby he agreed to ensure that all expenses of the
    unsupported costs   project are reasonable and necessary. Section 9(c) of the
                        Regulatory Agreement provides that the mortgage property,
                        equipment, building, plans, office, apparatus, devices,
                        books, documents, and other papers thereto, shall at all
                        times be maintained in reasonable condition for proper
                        audit and inspection. The owner shall keep copies of all
                        written contracts or other instruments that may be subject
                        to inspection and examination. HUD Handbook 4370.2,
                        Financial Operations and Accounting Procedures,
                        paragraph 2-6E, provides that all disbursements from the
                        regular operating account (including checks, wire transfers
                        and computer generated disbursements) must be supported
                        by approved invoices, bills, or other supporting
                        documentation.

                        The owner disbursed $18,765 for costs that were not
                        necessary and reasonable ($15,558) and for unsupported
                        costs ($3,207). Appendix C provides a detailed listing of
                        the unreasonable and unsupported costs discussed below:

                        •   Management fee $8,140 - We question management
                            fees paid to the owner/manager because he did not
                            fulfill management responsibilities. He did not comply
                            with the management certification, and with HUD
                            requests for information and to obtain professional
                            management. The owner caused significant violations
                            as noted by the audit. We calculated the $8,140 fee
                            based on the 5 percent fee rate applied to project
                            revenues as stipulated in the management certification.




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                                                                         Finding 1

                     •   Vehicle expenses $4,421 – The owner paid another
                         entity, Armfield, $4,000 for a 1993 model truck he sold
                         to the mortgagor entity, Magnolia Lane Apartments,
                         Inc. The owner provided a title that showed he owned
                         the truck and that he signed the title over to Magnolia
                         Lane. We did not determine why the owner made the
                         check payable to Armfield versus to himself. The
                         owner also paid $255 for insurance and a $165 tag fee
                         for the truck. HUD should assess the reasonableness of
                         the price the project paid for the truck and whether the
                         48-unit project needed the truck.

                     •   Realty fees $2,997 - The owner paid fees to a firm that
                         assisted with renting up the project. The owner did not
                         execute a contract for the services. HUD questioned
                         the need for the services in a finding from its July 2001
                         monitoring of project operations. The owner did not
                         maintain invoices for some of the payments. In some
                         instances, the owner offset the fee against collections
                         and did not write checks for the payments. The owner
                         posted adjusting entries to record the non-check
                         transactions.

                     The owner also disbursed $3,207 for costs not supported by
                     invoices. Absent invoices showing the nature and purpose
                     of the expenses, eligibility cannot be determined. The
                     unsupported costs included $2,177 the owner paid to
                     himself for travel and other unspecified costs and $1,030
                     paid to vendors.


                     Without HUD’s prior written permission, owners shall not
    Unauthorized     convey, transfer, or encumber any of the mortgaged
    encumbrance of   property, or permit the conveyance, transfer or
    assets           encumbrance of such property (Regulatory Agreement,
                     Section 6(a)).

                     On February 1, 2001, the owner pledged $100,000 of the
                     project’s escrow account for operating deficit and working
                     capital as partial collateral for unspecified notes owed to an
                     individual. The owner executed an $80,000 personal note
                     with the individual on January 7, 1999, and another
                     $50,000 personal note on February 15, 2000. The notes



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   Finding 1

                       were not recorded in the project’s general ledger.
                       Subsequently, the individual filed suit against the owner for
                       non payment of the note. The complaint showed the owner
                       used his home and project assets to secure the note.


                       “Although the audit did not include a review of
    Auditee comments   construction activities and costs, it is imperative that such
    (summary)          issues be considered in order to ensure that a fair and just
                       conclusion is reached regarding the project’s financial
                       records and expenditures. From the very inception of the
                       construction process, the owner, in addition to everyday
                       management activities associated with the property, was
                       forced to address significant problems brought on by the
                       contractor’s refusal to comply with the contract of
                       construction and other HUD requirements. To attempt to
                       analyze the project’s financial records outside this context
                       is both unfair and misleading. Particularly where many of
                       the obstacles the owner was forced to overcome were
                       perpetuated, if not directly caused by, the actions of certain
                       HUD representatives.”

                       The owner acknowledged that his lack of sophistication
                       regarding the regulatory requirements of HUD-insured
                       loans, as well as a corresponding lack of internal controls
                       did lead to several violations of the Regulatory Agreement.
                       “Any and all failures to adhere to said regulations were
                       either inadvertent or the result of the owners extreme
                       frustration experienced because of HUD’s refusal to assist
                       the property by helping him ensure the health, safety, and
                       welfare of his tenants.” The owner stated that at no point
                       did he ever intend to be anything but open and forthright
                       with regard to the management of project assets. The
                       owner stated that many of the irregularities noted in the
                       audit were made necessary by the negligence of the
                       contractor as well as HUD’s refusal to hold the contractor
                       accountable. The owner asks only that the findings and
                       recommendations made by the audit be considered in the
                       context of the situation in which he was placed. Given the
                       extreme shortage of revenue during the initial months of
                       operation the owner contends that he performed his
                       management and maintenance duties as best he could with
                       what was available to him.



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                                                                        Finding 1


                      The project’s owner, not HUD, has the responsibility to
    OIG response      address and resolve all problems associated with the
                      project’s development and construction. The owner’s
                      responsibility included but was not limited to pursuing
                      legal actions, if warranted, to assure contractor
                      performance; providing the cash needed to fund the
                      project’s construction and operations; and assuring
                      compliance with the Regulatory Agreement and related
                      HUD requirements. The owner claimed that many of the
                      irregularities noted in the audit were made necessary by the
                      negligence of the contractor as well as HUD’s refusal to
                      hold the contractor accountable. The owner’s comments
                      reflect an unwillingness to recognize that it was his
                      responsibility to address and resolve those issues.

                      Generally, the owner’s written response reiterated
                      information and arguments we considered while conducting
                      the audit. We did revise the report to reduce unsupported
                      costs by $1,019 ($75 for check 1075 and $944 for check
                      1206). The owner produced information that showed
                      vendors reimbursed the amounts to the project’s operating
                      account.



    Recommendations   We recommend

                      1A.    Continue ongoing efforts to complete the
                             mortgagee-in-possession to secure and protect
                             HUD’s interest in this project.      (HUD has
                             completed final recommended action.)

                      1B.    Debar the mortgagor and its individual principals
                             from future participation in HUD Programs.

                      1C.    Require the owner to reimburse the project
                             operating and trust accounts for $166,364 of
                             ineligible disbursements and $15,558 of costs found
                             to be unreasonable and unnecessary. Also, require
                             adequate documentary support, or reimbursement,
                             for $3,207 of unsupported costs. You should
                             coordinate action on this recommendation with our
                             office.



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                                                                                           Finding 2


     Misuse of Security Deposits and Prepaid Rent
   The owner improperly spent $43,225 of tenant security deposits and prepaid (last month) rent.
   The owner was not authorized to collect last month rent from tenants. As a result, project
   liabilities to tenants are not funded in trust accounts as prescribed by HUD regulations.
   Furthermore, the unauthorized collection of prepaid rent placed an unnecessary financial burden
   on tenants who moved into or wanted to move into the project. We attribute this violation to the
   owner’s failure to abide by HUD requirements.

   Without HUD’s prior written permission, owners shall not require as a condition of occupancy,
   any consideration or deposit other than the prepayment of the first month rent plus a security
   deposit in an amount not in excess of one month’s rent. Any funds collected as security deposits
   shall be kept separate and apart from all other funds in a trust account. The amount of the trust
   account shall at all times equal or exceed the aggregate of all outstanding obligations under said
   account (Regulatory agreement, Section 6(g)).

   At move-in, the owner required tenants to pay a security deposit and prepay the last month of
   occupancy rent. HUD requirements allow collection of security deposits, but HUD procedures
   do not allow, nor did HUD approve, the collection of prepaid rent.

   The owner deposited the $43,225 of security deposits and prepaid rent into the project operating
   account. As of December 15, 2001, the cash balance in the operating account was only $5,713,
   substantially less than the $43,225 liability for security deposits ($23,950) and prepaid rent
   ($19,275) at that date. The balance in trust accounts should have equaled or exceeded the
   aggregate of all outstanding obligations reflected by the liability accounts.            As of
   December 15, 2001, the general ledger trust account for security deposits contained a zero ($0)
   balance.

   The certified public accountant’s audit of the mortgagor’s cost certification, dated
   February 19, 2001, contained a finding concerning the owner’s failure to maintain a separate
   trust account to fund security deposits. The report indicated that the owner would establish and
   fund a separate trust account for security deposits.

   The owner stated that he spent the funds versus depositing them in trust accounts because the
   project needed the money to pay operating costs. We disagree. The project generated sufficient
   cash to pay all routine costs of project operations, fund trust accounts, and pay some mortgage
   payments. The ineligible and unnecessary costs identified in Finding 1 ($181,922) would have
   funded the $43,225 trust account plus six $21,132 mortgage payments. We conclude that the
   owner did not make a good faith effort to pay any mortgage payments and his mismanagement of
   project funds was a significant cause of the mortgage default.




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   Finding 2


                       The OIG is correct, the funds have since been repaid in full
    Auditee comments   and a separate account has been established as required under
                       the Regulatory Agreement.


                       The owner provided documentation indicating that it had
    OIG response       funded the security deposit account. However, the owner’s
                       comments did not address actions, if any, taken to resolve
                       the prepaid rent issue.



    Recommendations    Recommendations under Finding 1 address all needed
                       recoveries. No further recommendations for Finding 2 are
                       deemed necessary. The prepaid rent trust accounts should
                       be funded with the funds recovered under Recommendation
                       1C and the money should be returned to the tenants.




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   Management Controls
   In planning and performing our audit, we considered management controls systems of Magnolia
   Lane Apartments to determine our auditing procedures and not to provide assurance on
   management controls. Management control includes the plan of organization, methods and
   procedures adopted by management to ensure that its goals are met. Management controls include
   the process for planning, organizing, directing, and controlling program operations. They include
   the systems for measuring, reporting, and monitoring program performance.

   We assessed the following management control category that we determined to be relevant to our
   audit objectives:

          •   Controls over compliance with laws and regulations
          •   Controls over the safeguarding of resources

   A significant weakness exists if management control does not give reasonable assurance that the
   entity’s goals and objectives are met; that resource use is consistent with laws, regulations, and
   policies; that resources are safeguarded against waste, loss, and misuse; and that reliable data are
   obtained, maintained, and fairly disclosed in reports.

   Significant weaknesses in the assessed controls existed with respect to the owner controlling and
   managing the project without regard for HUD program requirements and prudent financial
   management. We placed no reliance on the controls and instead sampled a large proportion of
   project disbursements. The control weaknesses were the primary causal factors for Findings 1
   and 2.




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   Follow-Up On Prior Audits
   This was the first Office of Inspector General audit of Magnolia Lane Apartments mortgagor
   operations.

   The latest independent audit of Magnolia Lane Apartments was for the Mortgagors Certificate of
   Actual Cost for the period ended December 31, 2000. The report contained one finding
   concerning the owner’s failure to establish a separate trust account to fund security deposits
   collected from tenants. The owner did not resolve the finding as reported in Finding 2 of this
   report.




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   Issue Needing Further Study and Consideration
   As discussed in Finding 1, the owner pledged $100,000 of the project’s escrow account for
   operating deficit and working capital as partial collateral for notes made from an individual.
   HUD staff state they were not aware of the transactions that occurred before during and after the
   period of project development (initial processing through construction). We did not audit the
   project’s processing and construction. However, the transactions involved a lack of disclosures
   that may have impacted HUD’s assessment of the owners’ ability to meet minimum equity
   requirements when it approved the project. We believe HUD should review this issue and assess
   its impact on the decisions HUD made relative to the owner and project.




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                                                                                         Appendix A


   Summary Of Questioned Costs

          Recommendation                                  Type of Questioned Costs
                                                         1
              Number                           Ineligible       Unreasonable2      Unsupported3
                1C                              $166,364             $15,558            $3,207




   1
       Ineligible - Costs that are questioned because of an alleged violation of a provision of a law,
       regulation, contract, grant, cooperative agreement, or other document governing the
       expenditure.
   2
       Unreasonable - Costs that are questioned because they exceed the costs that would be incurred
       by an ordinary prudent person in the conduct of a competitive business.
   3
       Unsupported - Costs charged to a HUD-funded or insured program or activity whose eligibility
       cannot be determined at the time of audit since such costs were not supported by adequate
       documentation.




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                                                                                  Appendix B


   Schedule Of Ineligible Distributions
                                                                      Portion     Portion Paid
                                                                       Paid       After HUD
                 Check                                  Ineligible     After       Warning
     Date       Number Payee                              Costs       Default        Letter
    Transfers to Other Accounts
    10/26/01         1301 Conway National Bank             $ 20,000     $20,000        $20,000
    11/06/01         1310 Conway National Bank               10,000      10,000         10,000
    11/27/01         1322 Conway National Bank                5,000       5,000          5,000
     12/4/01         1333 Conway National Bank                8,000       8,000          8,000
    12/12/01         1340 Conway National Bank               10,000      10,000         10,000
                           Subtotal                        $53,000      $53,000        $53,000

    Unauthorized Payments to or for Mr. Hicks
     Various     Various James Hicks                        $18,178     $12,651         $9,568
    06/15/01        1204 James Hicks                         10,000      10,000
    07/20/01        1223 James Hicks                          4,700       4,700
     08/9/01        1245 James Hicks                          4,200       4,200          4,200
    10/15/01        1298 James Hicks                          1,335       1,335          1,335
     1/18/01        1083 Conway Hospital                        276
     1/31/01        1091 Conway Anesthesia Associates            41
      3/3/01        1117 Carolina Radiology                      98
                         Subtotal                           $38,828     $32,886        $15,103

    Unauthorized Payment for Washers and Dryers
      2/2/01        1095 Colortyme                            3,045
     3/15/01        1119 Colortyme                            3,045
     4/20/01        1153 Colortyme                              105         105
     5/31/01        1185 Colortyme                            6,090       6,090
     8/03/01        1240 Colortyme                            3,045       3,045          3,045
     8/07/01        1244 Colortyme                            3,045       3,045          3,045
     8/17/01        1253 Colortyme                            1,827       1,827          1,827
     9/10/01        1270 Colortyme                            4,263       4,263          4,263
     10/5/01        1290 Colortyme                            4,872       4,872          4,872
                         Subtotal                           $29,337     $23,247        $17,052

    Unauthorized Repayment of Loans
     1/12/01       1080 Conway National Bank                  1,199
      4/3/01       1133 Conway National Bank                  3,321       3,321
     4/18/01       1151 Conway National Bank                  1,607       1,607
     5/16/01       1179 Conway National Bank                  1,607       1,607
      7/2/01       1212 Conway National Bank                  1,607       1,607
     7/25/01       1225 Conway National Bank                  1,607       1,607          1,607
     9/05/01       1268 Conway National Bank                  4,820       4,820          4,820
     11/7/01       1316 Conway National Bank                  4,820       4,820          4,820
                        Subtotal                            $20,589     $19,389        $11,247

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   Schedule Of Ineligible Distributions

                                                                        Portion     Portion Paid
                                                                         Paid       After HUD
               Check                                      Ineligible     After       Warning
     Date      Number    Payee                              Costs       Default        Letter

   Unauthorized Payment of Legal Fees
     1/2/01        1059 Stuart Adramson                           500
    1/19/01        1084 Thompson Law Firm                         700
    5/16/01        1178 Thompson Law Firm                       1,890       1,890
    6/20/01        1205 Richard Lovelace                        1,000       1,000
    8/16/01        1251 Richard Lovelace                        4,000       4,000          4,000
    9/18/01        1274 Richard Lovelace                        1,411       1,411          1,411
    9/18/01        1272 James Hicks                             1,000       1,000          1,000
    10/3/01        1285 Richard Lovelace                        1,000       1,000          1,000
   10/31/01        1308 Richard Lovelace                        1,000       1,000          1,000
    12/3/01        1330 Richard Lovelace                        1,000       1,000          1,000
                         Subtotal                             $13,501     $12,301         $9,411

   Other Unauthorized Payments
     1/5/01         1066 Magnolia Lane Inc.                       300
     1/5/01         1067 Magnolia Lane Inc.                       200
     1/5/01         1068 H&H Investments                          376
     1/9/01         1076 Prudential Huntoon Paige               2,431
     5/3/01         1171 Lowes                                  2,134       2,134
     7/6/01         1217 Conway Air                             2,569        2569
    7/18/01         1222 Taryn McElhannon                         750         750
    8/10/01         1246 James Hawkins                          2,309       2,309          2,309
    8/11/01         1247 Taryn McElhannon                          40          40             40
                         Subtotal                             $11,109      $7,802         $2,349


                         Total                               $166,364   $148,625        $108,162




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                                                                                 Appendix C


   Schedule Of Unreasonable and Unsupported
   Costs
                                   Magnolia Lane Apartments

                                                         Unnecessary/
                                                         Unreasonable      Unsupported
       Date      Check No.                                  Costs             Costs

       Various    Various    James Hicks                      $    8,140
       1/24/01     1088      Agnis Armfield                        4,000
       2/26/01     1110      SCDPS                                   165
       3/27/01     1130      State Farm                              256
       4/27/01     1158      Ray Realty                              350
        5/3/01     1168      Ray Realty                              350
        8/9/01     None      Ray Realty                              375
        8/9/01     None      Ray Realty                              375
       9/18/01     None      Ray Realty                              395
       9/28/01     None      Ray Realty                              375
       11/6/01     1313      Ray Realty                              370
      12/11/01     None      Ray Realty                              407
        1/5/01     1061      James Hicks                                     $      300
       2/21/01     1101      James Hicks                                            300
       2/26/01     1109      James Hicks                                            300
       5/21/01     1180      James Hicks                                            400
       8/22/01     1257      James Hicks                                            377
        9/5/01     1265      James Hicks                                            500
       3/28/01     1131      CANNON'S                                                30
        6/2/01     1187      Delaney Richardson                                     500
        6/9/01     1198      Delaney Richardson                                     500
                                        Total             $       15,558         $3,207




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                                Appendix D


   Auditee Comments




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                                                                     Appendix E


   Distribution
   Auditee
   Principal Staff
   Regional Directors
   OIG Staff
   South Carolina State Coordinator, Columbia, South Carolina, 3ES
   Acting Director, Columbia Multifamily Program, 3EHM
   Acquisitions Librarian, Library, AS

   Sharon Pinkerton, Senior Advisor
   Subcommittee on Criminal Justice
   Drug Policy and Human Resources
   B373 Rayburn House Office Building
   Washington, DC 20515

   Stanley Czerwinski, Associate Director
   Resources, Community, and Economic Development Division
   U.S. General Accounting Office
   441 G Street N.W., Room 2T23
   Washington, DC 20515

   Steve Redburn, Chief Housing Branch
   Office of Management and Budget
   725 17th Street, NW, Room 9226
   New Executive Office Building
   Washington, DC 20503

   The Honorable Joseph Lieberman
   Chairman
   Committee on Government Affairs
   706 Hart Senate Office Building
   United States Senate
   Washington, DC 20510

   The Honorable Fred Thompson
   Ranking Member
   Committee on Governmental Affairs,
   340 Dirksen Senate Office Building
   United States Senate
   Washington, DC 20510




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   Distribution

   The Honorable Dan Burton
   Chairman
   Committee on Government Reform,
   2185 Rayburn Building
   United States House of Representatives
   Washington, DC 20515

   The Honorable Henry A. Waxman
   Ranking Member
   Committee on Government Reform
   2204 Rayburn Building
   United States House of Representatives
   Washington, DC 20515

   Andy Cochran
   House Committee on Financial Services
   2129 Rayburn House Office Building,
   Washington, DC 20515

   Clinton C. Jones, Senior Counsel
   Committee on Financial Services
   U. S. House of Representatives
   B303 Rayburn House Office Building
   Washington, DC 20515




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