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TheStreet Open House

Oaktree Profits Loom After Diamond Foods' Settlement With the SEC

NEW YORK (TheStreet) -- Diamond Foods (DMND) was able to remove a cloud hanging over the embattled snacks maker after it agreed to a $5 million settlement with the Securities and Exchange Commission on what the regulator alleges was an accounting fraud perpetrated by the company's former CFO Steven Neil and its CEO Michael Mendes, which allowed the company to misrepresent its financial condition to public shareholders.

While the SEC filed a complaint against Neil and a cease and desist order against Mendes, Diamond Foods will neither admit nor deny wrongdoing in its $5 million settlement.

Neil and Mendes are accused of under-reporting Diamond Foods' walnut procurement expenses in order to manipulate the company's profitability higher, meeting financial targets. Those accounting misrepresentations, when unmasked by an independent review of Diamond Foods finances, caused shares in the company to plummet in early 2012.

The SEC said on Thursday its settlement with Diamond took into account the firm's cooperation on their investigation and remedial efforts that were implemented once the fraud came to light. Diamond Foods hired restructuring specialist AlixPartners and interim CEO Brian J. Driscoll, to clean up the company's finances. As a result of Diamond Foods alleged financial fraud, the firm was forced to restate multiple years of earnings and was unable to file updated financial reports, putting the company in breach of debt covenants and nearly causing the delisting of its stock from Nasdaq.

Mendes, the former CEO, has agreed to pay a $125,000 penalty without admitting or denying the SEC's allegations. The former executive also forfeited $4 million in bonuses and benefits, the SEC said. On Thursday, the SEC filed a civil action on multiple counts of securities laws violations against Neil.

While Thursday's settlement contains all of the sordid details of Neil's alleged fraud and confirms much of what the media believed went awry at the once-high flying snacks seller, the bigger story for the remainder of 2014 may surround the investors and lenders who staked their money in helping Diamond Foods to weather a cleanup of its business.

Notably, Oaktree Capital Management (OAK) provided Diamond Foods with a $225 million high-cost loan to help the company in its efforts to ward off creditors and continue operating as it sought to work past Neil and Mendes' alleged fraud. Those loans carried an interest rate of 12%, roughly double the company's previous bank financing, and stipulated that the distressed debt investor would receive warrants for roughly 20% of Diamond Foods stock if it couldn't meet certain financial targets by January 2013.

Diamond Foods, however, failed to meet targets that would expunge Oaktree's low-cost stock warrants, which carry a $10 a share exercise price.

Nevertheless, with the SEC's review concluded and at a cost that Diamond had already reserved for, the company may be able to redeem Oaktree's high-yielding notes. Already, Diamond Foods indicated on a Dec. 5 quarterly conference call that the company is in a financial position to redeem Diamond Foods notes, something that analysts generally expect to happen in 2014.

That may be disappointing to Oaktree, which is currently receiving coupons that are more than double returns on high yield bonds. Still, the distressed debt investing giant may be poised for a big payout.

Oaktree is currently deeply in the money on its Diamond Foods stock warrants. Their 4.4 million stock warrants carry an exercise price of $10 a share, while Diamond Foods shares traded as high $25.85 on news that the company had settled with the SEC on Thursday.

In its most recent quarterly report, Diamond Foods disclosed that the fair value of its Oaktree warrant liability was $75.1 million. Were those numbers to hold up in an exercise of the warrant, it would amount to a significant payoff for Oaktree Management in a short time span.

Diamond Foods former executives may well have made serious misrepresentations about the company's growth prospects. Those alleged misrepresentations scuttled an acquisition of Pringles from Procter & Gamble and inflicted serious losses on ordinary investors who relied on Diamond Foods financial statements.

Nevertheless, Oaktree's deal, forbearance agreements with a syndicate of lenders and Nasdaq's leniency in allowing Diamond Foods to remain a listed stock gave the company the time it needed to move past the alleged financial fraud. For that, Oaktree is likely to see a handsome payoff, while some investor losses may be mitigated.

Oaktree Capital Management and Diamond Foods declined to comment, as did the Securities and Exchange Commission.

-- Written by Antoine Gara in New York

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