Lumber Liquidators' Legal Woes Still Loom Following Felony Plea

A Lumber Liquidators store in San Francisco.

Photographer: David Paul Morris/Bloomberg

Lumber Liquidators Holdings Inc. investors showed relief last month when the company resolved a U.S. federal investigation over importing flooring made with illegal timber.

After the company agreed to pay nearly $13.2 million in penalties in October, its stock surged almost 30 percent over two days. The move ended one of two probes for Lumber Liquidators -- the other one centering on whether its flooring contained dangerous levels of formaldehyde -- and shareholders were happy for the resolution. But its legal woes aren’t over.

As part of Lumber Liquidators’ deal with the government over the lumber case, the company pleaded guilty to five offenses, including a felony for making false statements. The U.S. Justice Department described its crimes as “ignoring its own red flags” in a “race to profit.” Both probes center on the company’s suppliers in China. And the past offenses may bring added scrutiny from the U.S. agencies currently investigating the company, according to Wendy Patrick, a veteran criminal trial lawyer.

While Lumber Liquidators is taking steps to improve its procedures -- including hiring a chief compliance officer -- investors and analysts are still waiting to learn the full extent of its legal challenges.

“It’s clear that the board has stepped in and is making an effort to clean up this company, but we’re not sure that all the shoes have dropped yet,” Bradley Thomas, an analyst for Keybanc Capital Markets.

Revamping Supply Chain

Lumber Liquidators, based in Toano, Virginia, said this week that it’s working with external experts to refine its supply chain.

“The company will continue to improve its procedures on an ongoing basis and looks forward to working with suppliers to set the highest standards for sourcing of wood products in the industry,” according to an e-mailed statement.

U.S. regulators began investigating the formaldehyde allegations after “60 Minutes” accused the company in March of selling Chinese-made laminate flooring with excessive levels of the substance. Since the first airing of the report, which showed people ripping floors out of their homes, the stock has plummeted more than 70 percent and both the chief executive officer and chief financial officer have departed. Sales fell 5.8 percent in the second quarter, and gross margin shrank by 15 percentage points. The company’s legal bills surged.

Earnings Due

As Lumber Liquidators prepares to deliver its latest quarterly results on Wednesday, last month’s rally has evaporated. The stock has declined in eight of the past 12 days. Fifteen of 16 analysts who cover the stock have the equivalent of a hold rating on the shares, according to data compiled by Bloomberg. One has a buy.

“The fundamentals have obviously deteriorated as customers have chosen not to shop at Lumber Liquidators,” Thomas said.

Investors have focused more closely on the formaldehyde probe, which involves the U.S. Consumer Product Safety Commission and Federal Trade Commission. But the timber investigation stemmed from the same place: the company’s operations in China.

In 2008, the U.S. amended the Lacey Act to make it illegal to import goods made from trees cut down in protected areas. The company used false information on documents and imported wood flooring made with timber that was illegally harvested, according to the plea agreement. The wood was alleged to have come from parts of eastern Russia that are protected to preserve the habitats of endangered animals like the Siberian tiger.

“Lumber Liquidators knew it had a duty to follow the law, and instead it flouted the letter and spirit of the Lacey Act," John Cruden, assistant attorney general for the Justice Department’s Environment and Natural Resources division, said in a statement announcing the plea deal.

Documents Questioned

In one example disclosed in the agreement, an employee alerted several parts of the company, including the legal department, that its import documents for shipments from a major Chinese supplier had false information. The employee said that the paperwork indicated the timber had been harvested in Germany, when it had actually come from eastern Russia. Despite this discovery, the company kept buying this kind of wood from that supplier and submitting the false documents, the Justice Department said.

Lumber Liquidators said this week that it’s working to implement the environmental compliance plan that was agreed upon with the Justice Department, “which we believe will set a new compliance standard for the industry. As part of that plan, the company will engage in a risk-based approach to sourcing in an effort to ensure that it is utilizing its resources effectively.”

Lingering Effect?

One question is whether the felony plea from the timber suit could affect the formaldehyde probe, said Patrick, who also serves as a business ethics lecturer at San Diego State University.

“Like any other area of the law, felony convictions involving illegal activity and ethical breaches affect the perceived corporate character,” she said. “That often influences subsequent investigations.”

The “60 Minutes” report, which used undercover reporters and hidden cameras, found that flooring was billed as meeting California health and safety standards even though tests run by “60 Minutes” indicated that it didn’t. Video showed managers at three Chinese factories used by Lumber Liquidators admitting to using false labeling that made it look like the products met regulations. In responding to the report, Lumber Liquidators said “60 Minutes” used the wrong tests. In its investigation, the Consumer Product Safety commission has said it will use different methods.

California Standards

“60 Minutes” also said it tested flooring from China that was being sold in several states outside of California, including Virginia, Florida, Texas and New York. Of the 31 products tested, only one would have been legal in California, according to the show.

Whitney Tilson, an investor who bet against Lumber Liquidators’ stock and then brought the formaldehyde allegations to “60 Minutes,” has pointed to the company’s higher profitability in recent years. Its gross margin, which was 35 percent in 2011, surged to 41 percent in two years. Over the past 12 months, gross margin has slipped back down again.

As part of the timber plea deal, Lumber Liquidators agreed to a five-year compliance plan. It has three months to meet the guidelines, or be banned from importing hardwood flooring until it does. The company has also created a special committee of independent directors to review its practices with help from an outside firm.

“What is difficult for us to get our hands around right now,” said Keybanc’s Thomas, “is how bad the legal and regulatory liability could be.”

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