A loan scandal that caused shares of Bank of Lancaster County's parent company to plunge nearly 40 percent last week compelled spokesman Pete Hudson to say, "It's obviously a serious situation."

But just how serious?

Many analysts believe Sterling Financial Corp. will be sold because fraud at its affiliate Equipment Finance Inc. will force the company to take a charge of up to $165 million.

Wilson Smith, of the Boenning & Scattergood investment firm in West Conshohocken, said management will face a difficult task in saving the bank and holding company.

"It was always considered to be a well-run bank in a very attractive market," Smith said. "It's a shame that certain members of management and workers at EFI decided to defraud the company."

Roger Moyer, Sterling chief executive, said staff at EFI colluded to conceal loan losses, falsify contracts and subvert internal controls in a "sophisticated loan scheme."

The fraud at EFI, based on West Airport Road off Lititz Pike, occurred with contracts related to logging equipment, mainly in the Southeast and may date back to 2004, Sterling reported.

EFI employees at various levels, including executives, were involved, Moyer said. Sterling fired five employees at EFI, but did not name them.

"It's difficult to understand how this went on for so long, but five people can cover up a lot in an office where you might have 20 to 30 employees," Smith said.

There were actually 18 employees at EFI before the scandal was exposed, according to Sterling.

EFI president George Graner voluntarily stepped down as president, Moyer said Thursday, but he would not say whether he continues to be paid.

Sterling, at 101 North Pointe Blvd., said federal authorities are investigating EFI.

Sterling, has hired an outside agency to advise on options, including raising capital, selling assets or businesses, and perhaps "entering into a business combination with a strategic partner."

Although Sterling has not determined when or for how long the fraud at EFI occurred, it is taking a cumulative after-tax charge of between between $145 million and $165 million against 2006 financial statements, where it reported a $36.5 million profit.

Smith said Sterling may rebuild capital by issuing additional stock, but said that if federal banking regulators decide the company's capital ratio doesn't meet legal guidelines, it "could be forced to find a strong partner."

Sterling's Hudson said a sale of the Lancaster County institution, established in 1863, is "no more or no less likely than other options on the table."

Bank of Lancaster County, EFI's direct parent, had capital of $195.1 million at the end of 2006. Its minimum capital requirement is about $171.5 million to maintain a "well capitalized" position, according to MonitorDaily.com, a publication that tracks the equipment leasing and finance industry.

To mitigate this problem, Sterling last week consolidated its other banking subsidiaries under the Bank of Lancaster County umbrella.

Under this scenario, the total capital of the "new" BLC would be about $312.7 million, based on Sterling's 2006 annual report.

So if one assumes the "worst case" — a $165 million hit to the capital accounts — Sterling's banks would have a stockholders' equity base of about $147.7 million, not nearly enough for its underlying banks (combined) to qualify under the minimum to be well-capitalized, MonitorDaily.com. reported Tuesday.

The company also faces six class-action lawsuits filed in the past week that allege it violated federal securities laws. Such lawsuits have become typical since the scandals at Enron, Tyco and WorldCom.

Moyer Thursday declined to explain how the fraud occurred at EFI .

Christopher Menkin, editor of Leasing News, a Saratoga, California-based publication that covers the leasing industry, has tracked Sterling and EFI for several years.

He said Thursday that neither company belonged to an equipment leasing association and therefore never got the benefits "of subjects regarding leasing, such as accounting, fraud, software and other services available to the industry."

Leasing News reported that unnamed sources said copies of checks sent to EFI did not exist and were double- and triple-counted as compared with the records in its the computer.

Hudson would not confirm Menkin's allegations and said any information from an unnamed source "is speculation, not fact."

Leasing News reported that certain EFI officers with a high credit approval had loans without proper documentation or procedure and that it appeared an internal Ponzi-type pyramid had been discovered.

Sterling's accounting departments became suspicious of some double booking and check payments on existing loans and evidently sought a paper trail, rather than the computer readout of accounts, Leasing News reported.

"It also appears that accounting records could be changed by code and/or authorization. For instance, missing checks in one month could be eliminated so the next month, the outstanding checks were no longer there, " Leasing News reported.

Lancaster native Robert D. Carl III is an investor who holds significant shares in community banks such as Fulton Financial Corp. and Leesport Financial Corp.

"I hope Sterling and Bank of Lancaster County can survive what must be the ultimate nightmare for a bank and its managers," said Carl, who founded and sold the parent company of Lancaster Magnetic Imaging to Health South for $280 million in 1997.

Carl said it was hard to understand the complacency of a management team that could allow EFI — an equipment leasing company with relatively small asset base of about $365 million — to generate 41 percent of the pretax net of Sterling, a $3.3 billion bank-holding company.

"Sterling's management apparently relied far too long on the earnings contribution of EFI," Carl said. "EFI was lending at rates of 14.5 percent and taking little reserves for bad debts. It was simply too good to be true and, in fact, wasn't true."

Established in 1945, Equipment Finance was acquired by Sterling in 2002 for $30.5 million in stock and cash.

In its 2006 annual review filed April 2, the company said Equipment Finance is "one of Sterling's true performance success stories," originating more than $115 million in new contracts with assets increasing to more than $300 million in 2006.

Sterling last week said the fallout from the scandal would not cause immediate layoffs within the firm's 1,100 employees.

However, Sterling's plummeting stock price has affected Sterling Financial Corp.'s employee 401(k) retirement plan, which has about 1.5 million shares of Sterling stock.

"The stock price has dropped, and employees who have portions of their retirement assets invested in the Sterling Stock Fund have experienced these unrealized losses in that component of their retirement," Moyer said Thursday.

Sterling last month learned of the contract irregularities at Equipment Finance and announced April 22 that it would postpone the release of its first-quarter earnings.

Recently, Nasdaq informed Sterling it is subject to delisting from the stock exchange because it has not complied with a first-quarter earnings report filing deadline of May 15. Sterling is appealing, and its shares continue to trade.

Sterling's shares fell $6.19, to $9.97 on the Nasdaq last Friday. The price has leveled off since, closing at $9.88 Thursday, but is off more than 50 percent this year.

E-mail: pburns@lnpnews.com