Less than two weeks earlier, the company reported that it had received information of irregularities in certain financing contracts in one of its financial services group companies — Equipment Finance, LLC (EFI). An audit committee was immediately adjourned and expert accountants retained.

Without explaining exactly what led to the discovery or how long Sterling executives had known something was amiss, the company issued a statement pledging to get to the bottom of it.

“Sterling is committing all necessary resources to complete the investigation in a thorough, timely and professional manner and to take any corrective steps necessary,” the company said in a release.

By the middle of May, the “irregularities” had blossomed into a full-blown fraud scandal at Sterling — one that reached into the highest echelons of EFI management.

Five EFI employees were subsequently terminated, including the chief operating officer and executive vice president. To this day the company has not revealed their identities.

George W. Graner, the president and CEO of EFI, resigned his position as the problems mounted. He has not been formally implicated in the scam.

As news of the scandal unfolded, J. Roger Moyer, Jr., Sterling’s president and chief executive officer, described a complex and highly evolved scheme that was able to elude the company for years.

“Our investigation has now revealed evidence that Sterling and its shareholders were subjected to a significant, sophisticated loan scheme, specifically designed to deceive and avoid detection,” Moyer said in the days following the company’s May 24 announcement revealing the extent of the scam.

The internal investigation revealed evidence of a sophisticated loan scheme, orchestrated deliberately by certain EFI officers and employees over an extended period of time. According to the company, the conspirators concealed credit delinquencies, falsified financing contracts and related documents, and subverted the corporation’s established internal controls and reporting systems.

How well the scheme was hidden is underscored by the fact that as recently as March 15, Ernst & Young rendered a routine opinion to the effect that Sterling had indeed implemented effective internal controls over its financial reporting for the year ending December 31, 2006.

Nancy Geary, a partner in Illinois-based ECS Financial Services who is both a CPA and a CLP, says it would be difficult under the circumstances for an independent audit to uncover the collusion.

“When you have so many people working together to effect a fraud, it’s very hard to find something like that,” admits Geary. “You have a whole department that’s working to cover it up and so there is no guarantee you’re going to find something.”

By April 30, the company told the SEC in a filing: “The reports on the audited financial statements for the three years ended December 31, 2006 and related reports on internal control issued by the corporation’s independent registered public accounting firm, Ernst & Young LLP, should no longer be relied upon.”

The news was a devastating blow for the company and its shareholders. On May 25, the day after the fraud was revealed, shares of Sterling plunged 40% to an intraday low of $9.31. It’s 52-week high was $24.20.

Sterling Financial has banking subsidiaries in three states and provides equipment financing up and down the East Coast. At the end of 2006, the company reported $3.3 billion in assets and as recently as August 2006 was rated one of “America’s Finest Companies.”

Sterling acquired EFI in 2002 for roughly $30 million. The company provides commercial financing for the soft pulp logging and land-clearing industries, primarily in the Southeastern U.S.

The unit quickly defined itself as a golden goose for Sterling, and in 2006 provided more than 41% of the bank’s net income from continuing operations despite representing only 9% of its consolidated assets.

According to Sterling’s 2006 10K released on January 23, 2007: “One of Sterling’s true performance success stories is Equipment Finance LLC… EFI is a leader in its industry and originated more than $115 million in new contracts with assets increasing 20% to more than $300 million in 2006.”

How the breakdown occurred is still a mystery and while Sterling executives are trying to figure out exactly what happened, this much seems clear: Sterling was highly overexposed financially to the EFI business, a fact that only made the meltdown that much more painful.

As www.monitordaily.com reported on May 29, the concentration of EFI-related risk has been growing as a percentage of Sterling’s net income since the acquisition of the company five years ago. Over the past few years, for example, EFI represented about 38% and 36% of the holding companies’ net income from continuing operations in 2005 and 2004, respectively.

In hindsight it’s easy to suspect EFI’s phenomenal success may itself have been a red flag. When considered in the context of Sterling’s loan portfolio at year-end 2006, finance receivables, net of unearned income, accounted for 15.8% of the total loan portfolio of $2.4 billion.

Yet, curiously, despite showing $373.5 million, $310.8 million and $236.6 million in net finance receivables at year-end 2006, 2005 and 2004, respectively, the company reported no charge-offs for finance receivables over the three-year period.

What’s more, the 2006 annual rate on average finance receivables — believed to be mostly attributable to EFI — was 14.5%, almost double what was shown for other core loan activities. This suggests a risk level at EFI that should have perhaps raised eyebrows given a no charge-off scenario for so long.

Referring back to its 2006 annual report, Sterling explained, “Charge offs are insignificant, a tribute to the proactive relationship management practices of EFI.”

EFI’s management may indeed have been proactive, but clearly not with the company’s interests in mind. While it’s too early in the investigation to tell exactly what their motivations were, the EFI conspirators have, for the moment at least, succeeded in bringing Sterling to its knees.

How nobody saw it coming is an issue that will likely come up in the coming months. Reached for comment, a Sterling spokesperson says the company is in the midst of an ongoing investigation and is currently cooperating with federal authorities. As he explained it, the fraud was so well orchestrated that it’s no wonder no one picked up on it for so long.

“This was collusion that happened at several different levels that made it possible for one person to cover for another,” explains spokesperson Michael Lambert. “When you have multiple people involved it’s difficult to detect.”

Others aren’t so sure. After shares of Sterling dropped more than 50% from its 52-week high, lawyers wasted no time jumping into the fray. There are currently more than ten firms representing shareholders in class action suits against Sterling, most of them filed in U.S. District Court for the Southern District of New York.

Attorneys for the shareholders declined an invitation to comment, citing the ongoing litigation, but court records indicate the plaintiffs intend to show that Sterling upper management — including Moyer, Graner and Sterling’s former and current CFOs — were complicit in the fraud.

“It’s somewhat common in a situation like this, where a firm’s stock falls significantly, that a company will see these kinds of suits pop up; we are going to defend ourselves vigorously,” says Lambert.

Meanwhile, rumors that the company may be poised for a buyout were temporarily quelled by the recent decision by Manufacturers Traders and Trust Company to pump $80 million into the bank.

Sterling said the money would be used to reinforce operating capital and to repay outstanding debt of EFI.

The infusion of cash was necessary if Sterling wishes to remain fully capitalized following the $145 million to $165 million hit it expects to take when it re-files its 2006 annual report. When that will finally happen, though, is still anyone’s guess.