Rise and fall of Renegade

 In 2014-10

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Calvin Phelps could often be found praying in his office. He served the holiday meal to his employees. He could fix just about anything that had an electric cord or an engine. But in the end, being a generous boss who was good with his hands wasn’t enough. He also fought the state and federal government over taxes and other payments. He treated his companies like personal piggy banks. He bought a mansion, then lost it after his companies filed for bankruptcy. He went to federal prison this year after pleading guilty to fraud charges.

Phelps owned a tangle of companies known to the public as Renegade Tobacco Co. They were based in Farmington, between Winston-Salem and Mocksville. Started from nothing in 1994, in their heyday they had sales of more than $50 million and employed nearly 140 people. The factory is closed. The companies are nearly dissolved. The jobs are gone. The lawyers and consultants have spent the better part of six years squabbling over how to divide the assets and, in the process, collected more than $2.6 million in fees. Renegade Tobacco’s rise and fall is a messy tale of greed and ambition, competition and regulation. It’s about the search for the next loophole and what happens when small companies make enemies of larger ones. In the end, it’s about cigarettes and the forces that make these exquisite little packages of paper and tobacco the perfect device for delivering nicotine, profits and tax revenue.

Phelps, who declined to be interviewed, is 52. He grew up the son of millworkers in what is now the outskirts of Clemmons in western Forsyth County. His father, Arthur, was a decorated war veteran who worked 45 years for Winston-Salem-based Hanes Corp. His mother, Mary, worked there 25 years, then became a licensed practical nurse. They died — she of breast cancer, he of pneumonia — the same day, March 22, 2005. At the time, Arthur was honorary chief executive of Renegade Tobacco.

Their son earned an associate’s degree in engineering and electronics technology from Forsyth Technical Community College in 1981 and two years later went to work for Winston-Salem-based R.J. Reynolds Tobacco Co. Starting as a technician, he became a maintenance planner, taking care of the making-and-packing machines, which can produce thousands of cigarettes a minute. He left Reynolds in 1990 and, four years later, started PTM Technologies Inc., which bought, sold and repaired used making-and-packing equipment. He began manufacturing herbal cigarettes, including a product called “Cannabis Free,” under a second company, Alternative Brands Inc. But you can only make so much money selling fake joints. His big break was about to happen, courtesy of his old employer and the rest of Big Tobacco.

The Master Settlement Agreement between the nation’s largest tobacco companies, 46 states and six other jurisdictions was signed Nov. 23, 1998. The states agreed not to bring lawsuits against the tobacco companies to recover health-related expenses, and the tobacco companies agreed to pay the states more than $200 billion through 2025. The payment, which was $7.6 billion last year, is prorated to the states through a formula calculated out seven places past the decimal point. They are collected through an assessment on each carton; the current level is more than $5.

At the time of the MSA, the four major cigarette manufacturers controlled about 95% of the domestic market, and their concern was that companies that weren’t parties to the agreement — and didn’t have to make the payments — could undercut their prices. So part of the deal created a separate category of tobacco companies, known as nonparticipating manufacturers — NPMs. Instead of making payments to the MSA, they had to put a similar per-carton amount into escrow accounts in the states where they operated and keep it there for 25 years, in case these states decided to bring additional health claims. Though many of the country’s top lawyers helped draft the MSA, the final document was flawed, creating a gift for Little Tobacco. These small manufacturers were allowed a substantial rebate on their escrow payments based on the difference between the percent of their sales in a single state and that state’s share of the whole MSA pie.

Renegade Tobacco Co. began in 1999 with a brand called Tucson. Phelps was the only shareholder. Eventually, the corporate structure became more convoluted: Phelps owned Compliant Tobacco Co., which in turn owned Renegade Holdings. Renegade Holdings owned four companies: Renegade Tobacco, Alternative Brands, PTM Technologies and Dogwood Winery and Vineyards. Besides buying and selling tobacco-manufacturing equipment, PTM also owned the equipment used by Alternative Brands. And despite its name, Dogwood wasn’t in the wine business; it made filters, which were then sold to Alternative Brands and other small manufacturers.

Phelps concentrated his business in North Carolina. Along with the escrow advantage, it was also easier to distribute his products in a smaller geographic area. Other little manufacturers — such as S&M Brands Inc. in Keysville, Va., and Farmers Tobacco Co. of Cynthiana, Ky. — used the same tactic to great success. From 1999 to 2003, the NPM share of the cigarette market more than doubled, soaring from 3.8% to 8.4%.
Not everybody was cheering. The big tobacco companies were watching their volumes drop, and the states faced a different problem, because their payments — used by individual states to do everything from improve public health to balance budgets — were tied to the majors’ market share. The solution was to close the escrow loophole, and states began amending their tobacco-settlement statutes in 2003. North Carolina’s law was changed in 2005. “As a result,” according to a pleading by an attorney for Phelps, “Alternative Brands’ regulatory costs rose dramatically. To make matters worse, these amendments were applied retroactively. Like many other NPMs, Alternative Brands was faced with two choices: close its doors, or become a member of the MSA.”

Phelps tried to join the MSA, but he plotted a route through the backdoor. In January 2006, he gained control of a company called Cutting Edge Enterprises Inc., which had started in Baltimore. Its founder had signed the MSA as part of a group known as Subsequent Participating Manufacturers — SPMs — but Cutting Edge had never made a cigarette. Phelps assigned Cutting Edge rights to sell Tucson, with Alternative Brands as the contract manufacturer. The idea was that because Cutting Edge was already a member of the MSA, there was no need for back payments. It was clever — perhaps too clever.

One by one, state attorneys general delisted Cutting Edge’s brands. In response, Cutting Edge filed an antitrust lawsuit in U.S. District Court for the Southern District of New York against the National Association of Attorneys General. (It is known as NAAG and, perhaps not surprisingly, pronounced “nag.”) Leading the Phelps litigation was a Louisville, Ky., lawyer named William Hunter, who had been one of the MSA negotiators. He argued that the owner of a participating manufacturer — as long as it was a signatory to the agreement — did not matter and that contract manufacturing was common in the cigarette business. (Hunter declined to comment; he has continued to represent the Phelps companies in various litigation through their bankruptcies.)

The states pushed back hard. Maryland sued Cutting Edge, contending that the purchase was a shell game designed to duck $65.9 million in back MSA payments. “As both an SPM and an NPM,” the state’s attorney argued, “Mr. Phelps wishes to take advantage of each status while meeting the obligations of neither.” The attorneys general asked for a ruling on jurisdiction in the federal lawsuit. They claimed that NAAG was not legally a party to the agreement and that any litigation needed to be done state by state. The antitrust case was dismissed March 6, 2007. Phelps had spent $2.3 million on legal fees on this and other battles but had little to show for it.

Cutting Edge was forced into bankruptcy a month later. The company was liquidated, though not before making a final run at the attorneys general in hopes of striking a deal and perhaps stretching out back payments to give it time to find its footing. An agreement was said to be close, but one of Phelps’ lawyers, Christie Moore, would later say in court papers, “NAAG advised Calvin that RJR and Philip Morris had challenged the offer pursuant to the most-favored nations clause in the MSA. NAAG withdrew the offer.” The tobacco companies and NAAG declined comment, but the history of small manufacturers becoming successful players under the shelter of the MSA has not been encouraging. The founders of Farmers Tobacco, for example, tried to join, and their back payment was so large the owners ended up selling cigarettes off the books to help pay the debt. They went to prison.

Bryan Haynes, a partner at Troutman Sanders LLP law firm in Richmond, Va., has worked with small manufacturers on a variety of regulatory matters. While he says there is an argument to be made that the escrow changes were simply to keep the playing field level, the effect is clear: “The states have an interest in seeing that NPMs don’t encroach on the big boys’ market share.” Ronnie Smith, who worked in sales at Renegade, put it this way: “The attorney generals were always after small cigarette companies, but they seemed to target us.”
It was at this particular juncture that Phelps bought a house. And not just any house. Chinqua-Penn Plantation sits on an old country road on the outskirts of Reidsville. It is one of North Carolina’s great estates, built in 1925 by Thomas Jefferson Penn, whose family helped found American Tobacco Co. It is an eccentric folly, 31,000 square feet — part lodge, part farmhouse, part manor — and was filled with art and antiquities collected during the Penns’ travels around the world. Penn died in 1946, and his widow gave the property to the state in 1959, with the goal of making it a museum. It was never quite successful enough, and in 2004 the state put the house and its contents up for sale.

In July 2006, it found a buyer. Phelps agreed to pay $4.1 million. In interviews, he would note that years earlier he and his wife, Lisa, had visited the estate on their first date. The Phelpses wrote a memo to the state, entitled “Vision and Purpose,” promising to restore Chinqua-Penn and make it a premier destination for weddings, conferences and retreats. Sales of state property must be approved by the N.C. Council of State, which is composed of statewide elected officials, including Attorney General Roy Cooper. At the time, he was one of the defendants in the Cutting Edge case. If he had concerns about the deal, he didn’t speak up. The sale was approved unanimously. A spokesman for Cooper says he had no reason to tie the real-estate sale to the lawsuit.

Phelps took out a $2 million mortgage from Atlanta-based SunTrust Banks Inc. Most of the rest — $1.8 million — he got from Alternative Brands. During the next two years, he would remove nearly $1.5 million from his companies to pay for renovations and other expenses at Chinqua-Penn. Problem was, the tobacco companies couldn’t spare the cash. They still owed the states back escrow payments, and the demands were starting to grow louder.

Cooper’s office filed suit in Wake County Superior Court against Alternative Brands and Renegade Tobacco Co. on July 20, 2007. The state claimed that the companies owed $6.8 million in escrow payments. It pushed for civil penalties up to $20.5 million and asked the court to prohibit the companies from selling cigarettes in North Carolina for two years. At the time, the Renegade companies were on pace to hit sales of $49 million and income of $5.9 million. In addition, they had a factory, nearly a dozen retail stores and about 100 employees. Getting shut down in North Carolina would have destroyed the businesses and killed all those jobs, so a deal was struck quickly in August 2007. The companies would pay their back escrow, then begin making 2007 payments in an orderly fashion. A few months later, Phelps was back at the negotiating table.

Richard Harrison, the special deputy attorney general who handled MSA matters, testified at a later court hearing that Hunter approached him in January 2008: He was worried that Renegade wouldn’t be able to make its April payment of $4.6 million. Harrison said he demurred on reopening the agreement because that deadline was still a few months away. Very quickly, he said, the attorney general’s office got a call from aides to Gov. Mike Easley: Legislators had contacted Easley’s staff with concerns about protecting the factory jobs. Renegade argued that, based on its financial projections, it needed 10 years to pay off the $4.6 million. Both sides agreed to three years, with monthly payments of $50,000 the first year, $100,000 the second and $263,000 the final year. It was a compromise born in part from the state’s earlier dealings with Phelps. “There was no way we were going to do a 10-year plan after the company’s and the owner’s behavior in the Cutting Edge bankruptcy,” Harrison said. The companies made 10 payments, then stopped. It wasn’t a lack of cash, just that the cash was going somewhere else.

Even before he bought Chinqua-Penn, Phelps, whose annual salary was $286,000, had been using his companies to pay for other stuff. He lent himself money, paid his taxes, bought guitars and went on his honeymoon to Thailand and Japan with funds from Alternative Brands.

A week after cutting the new deal with the state, Phelps formed Blue Ridge Airlines LLC, and the company borrowed $1.9 million in July from Greensboro-based Carolina Bank to purchase an Eclipse jet. Blue Ridge’s operating expenses for 2008, nearly $150,000, were paid by Alternative Brands and Renegade Holdings. And perhaps to celebrate a major equipment refinancing on May 9, 2008, Phelps bought a $142,000 Maserati Quattroporte, with the loan guaranteed by Renegade Holdings. Monthly payments: $2,497.46.

Ashley Rusher was one of the lawyers on the bankruptcy examiner’s team. She says the blurring of personal and corporate accounts is not uncommon with owners of closely held companies, though she was astonished by the magnitude of Phelps’ actions. “The problem comes into play when there are creditors who are not getting paid or the cash flow is being diverted into pet projects.”
Michael Mebane began working at Renegade in 2007, first as a consultant to help the companies secure new lines of credit, later as its president. He remembers his first day there. “You’ve heard of Barbarians at the Gate? I call this ‘Knuckleheads at the Door.’ We asked to see the financials, and they didn’t have any. They hadn’t had any for months.” He helped Phelps refinance operations to gain more favorable terms, including a new loan of $3.5 million from Mocksville-based Bank of the Carolinas. He was also part of the team that met with the attorney general in early 2008 to adjust the escrow payments and give Renegade some breathing room.

Despite those efforts, Mebane says he was concerned about the company’s long-term viability, and he said so in a memo to Phelps dated Nov. 25, 2008. “I am not sure you truly understand that liquidity is in jeopardy for January. We must take dramatic steps now to have any chance of operating through the next 90 days. Even with these steps, the April escrow obligation will not be met and the consequences of that must be discussed.” He recommended selling the airplane, sports car and estate and eliminating any expenses that weren’t part of the core business. “Any other uses of cash must be terminated immediately.”

It was too late. Renegade filed for bankruptcy protection Jan. 28, 2009. Its creditors fell into three groups: secured lenders, unsecured lenders and the states, which were owed millions in escrow payments and were skeptical of any plan that substantially subordinated these debts to other creditors. Making matters worse, the states didn’t trust Phelps. Word of his lavish spending was now well known. “It is of critical concern because it directly bears on whether the debtors’ owners and managers have the skill and judgment and fiduciary concern for the well-being of the debtors and their creditors to be left in charge of these operations on a going-forward basis,” Patricia Molteni, NAAG’s lead attorney, argued in a court brief from Aug. 24, 2009.

One of the key questions for reorganization is whether the company has a strategy to generate the earnings to pay off its debts. Renegade’s business had changed substantially after its escrow advantage was eliminated and it was unable to join the MSA. It had moved into making little cigars, which look and smoke a lot like cigarettes but were taxed at about a 10th the rate, only 40 cents a carton. But the government caught on to the dodge and closed the loophole in 2009.

There proved to be another port in the storm. Filtered cigars were still taxed at a lower rate, as little as $2 a carton. The U.S. Treasury’s Alcohol andTobacco Tax and Trade Bureau defined a filtered cigar in part by weight, and companies such as Renegade figured out that by adding the slightest bit of filter or tobacco to their products, they could turn little cigars into filtered cigars and regain an edge. “It’s the same product, the same market, just a different configuration of product to meet the TTB requirements,” Mebane testified March 10, 2010. As part of its reorganization plan, he and other Renegade officials projected a substantial increase in revenue from these new products. The states’ experts said they were unrealistic and urged the judge to reject the plan, in part because Phelps couldn’t be trusted to act responsibly.

John Northen, Renegade’s lead bankruptcy attorney, conceded that Phelps had misspent funds but told Judge William Stocks that the goal was to move forward and repay creditors. “The debtors’ obligation is not to try to punish Mr. Phelps for making a mistake,” he said. Over the objection of the states, Stocks approved the reorganization April 23, 2010. But he was forced to take it all back two months later. The case had changed. It was no longer just about a company that couldn’t pay its bills.
When Cutting Edge was dissolved in 2007, the company still had a lot of packaging for its Dallas and Makro brand left over. Phelps contacted a business acquaintance named Jerry Gammons, who operated a cigarette warehouse in the little crossroads of Guntown, Miss. Gammons had an export license, and he and Phelps agreed to falsify records and pretend to export cigarettes. Phelps sold nearly a million cartons (produced at a cost of between $1 and $2 a carton) to Gammons for $3.2 million and, in the process, avoided $5 million in MSA payments. There was just one problem: Gammons was working as an undercover FBI informant. Many of Phelps’ supporters think he was duped. “When I asked what happened regarding this situation, he told me, ‘I thought I was helping a friend in need,’” Gordon Stewart, a friend of the family’s, would later write. “This I believe, as he has always been fair and square with me.”

Phelps first learned he was the target of an FBI sting in early 2009, a few months after Renegade filed for bankruptcy. He and his lawyer at the time, Walter Holton of Winston-Salem, the former U.S. attorney for the Middle District of North Carolina, met with Mississippi officials in March 2009. Renegade’s bankruptcy team said they had been kept in the dark. Sort of. At a contentious court hearing May 25, 2010, the company’s attorneys said that they had only learned about the investigation April 7, two weeks before the reorganization plan was approved. But they didn’t bring it to the court’s attention, and they argued that the reorganization needed to be kept in place. “I didn’t think it was relevant or critical enough until there had been an indictment to attach,” says Robyn Whitman, with the U.S. bankruptcy administrator’s office. “And for that reason, I left it off. And for those same reasons, I don’t think it should be admitted.”

Not surprisingly, the states disagreed. This is how Molteni put it: “I don’t want to get ahead of myself. I don’t want to cast aspersions, but I don’t know. And it’s very troubling to me that none of us know and yet we have an order of confirmation. Bankruptcy is not intended to be a haven for criminals. It’s not intended to reorganize criminal enterprises.”

Stocks voided his confirmation order July 13, 2010. A month later, Phelps, who was still in charge, came into work and began firing the executives. Creditors quickly petitioned the court to have the company placed under the control of a trustee, removing Phelps from any role in the companies’ management. Trustee Peter Tourtellot, a partner in the Greensboro turnaround firm Anderson Bauman Tourtellot Vos & Co., brought back the old management, except for Mebane. Phelps had made him a scapegoat for the company’s problems, Tourtellot says. “There was no way I could bring Mike back, just for his own safety.”

Bankruptcy is not meant to be a permanent situation. The uncertainty of a company’s financial situation can ripple through its relationships with its vendors and customers. In addition, the expense of bankruptcy can be considerable. The debtors’ attorneys and consultants have to be paid, robbing the business of cash flow for operations.

For 2009, the Renegade companies had reported net income of $1.78 million on net sales of $32.7 million. Tourtellot continued to develop reorganization plans, but he also courted potential buyers. On July 19, 2011, he filed a motion to sell the company to Raleigh-based CB Holdings Inc. for $16.1 million. The deal was based on a big gamble. CB, which owned a handful of small tobacco brands, would buy the escrow accounts, now worth more than $50 million, at a steep discount of about $11.6 million, essentially betting that the states wouldn’t try to recover the money. But the sale fell through in early November after the attorneys general claimed they were owed an additional $16.7 million in escrow payments.

Tourtellot began a second attempt at reorganization, but now there was another tax problem. In 2004, Congress had passed a law that required companies to pay an assessment to fund the end of the tobacco-quota program. The government said Renegade needed to include that when calculating its excise-tax payment. Renegade said it didn’t, that the payment was a tax not an assessment and shouldn’t be levied twice. The maneuver had given them a price advantage, and the government wanted to take it away while also claiming back taxes, interests and penalties of $2.6 million. On Nov. 6, 2012, Judge Thomas Schroeder ruled against Renegade in U.S. District Court in Greensboro. Reorganization would have to wait.

Two years later, Tourtellot is still upset at the decision and thinks it robbed the companies of their best chance to emerge from bankruptcy. “The judge erred. The calculation that the TTB did was not legal. That’s why we fought it. I don’t think the judge ever understood — or maybe he did understand — just how much a deal this was, and therefore he didn’t want to hear it. Because this would have set the industry upside down if we had won.”

Even after the Renegade companies filed for bankruptcy, Chinqua-Penn remained in business as a tourist attraction, with Phelps a constant presence. The estate’s employees described him as being professional and personable. In April 2009, a travel piece in The Washington Post urged readers to visit: “Chinqua-Penn is rapidly winning us over, not with its art pieces, however spectacular, but with its charming, stupendous weirdness.” But it couldn’t last. On Sept. 24, 2010, the bankruptcy examiner filed a blistering motion against Phelps. It was sealed but has since been made public. The report says Calvin and Lisa Phelps violated a court order with intent to defraud creditors by not disclosing anticipated income-tax refunds for 2005 and 2006 totaling more than $1 million. An order was approved that day, and federal marshals began quickly seizing the Phelps’ assets, including Chinqua-Penn. The mansion closed and has not reopened.

The contents of the estate — 1,300 lots in all — were auctioned off in a two-day sale in April 2012 at the Greensboro Coliseum. A pair of bronze panther sculptures sold for $120,000; so did a Louis XV fountainhead that the Penns bought in Paris with the understanding it had originally been at Versailles. The total take was $3.3 million. A week later, Phelps’ guitar collection was auctioned, bringing in an additional $202,050, including $20,000 for a 1960 Gibson. The Chinqua-Penn property went into foreclosure. Now owned by SunTrust, it is for sale. Asking price is $1.35 million, though its value is still to be determined. Leland Little, whose auction company helped coordinate the estate sale, says that, stripped of its collections, Chinqua-Penn is just a big house in the country. “It’s a three-wheeled car.”

Two months after the auction, Phelps’ guilty plea was filed in U.S. District Court for the Northern District of Mississippi. His sentencing would be delayed nearly two years. At the time, he faced up to 43 years in prison. In a sentencing memorandum, his attorney explained what Phelps had done and why he had done it: “Given Calvin’s frustration with NAAG and, to him, its seemingly arbitrary decrees, the deal allowed Calvin to sell product without making any MSA payments. In his mind, this scheme, which he naively believed was a way to get back at NAAG through a breach of the MSA, allowed him to engage in some measure of ‘payback.’”

 

As Phelps awaited his sentence, the companies he founded were dying. Tourtellot and his legal team pushed forward a final reorganization plan on Feb. 2, 2013. Judge Stocks dismissed it, citing unrealistic sales projections. “There is a glaring discrepancy,” he wrote, “between the debtors’ past performance and what the trustee has projected for the future.” The last chance to save Renegade came on May 31, 2013, when Globe 360 Tobacco Inc., based in Doral, Fla., offered to buy the companies for $25 million. That deal also collapsed, because of objections from the states and equipment lenders who said they would be shortchanged. The businesses closed Aug. 23, 2013. At the time, they employed 83 people. What was left would be liquidated.

More than a year later, lawyers are still fighting over the carcass. Most of the making-and-packing equipment, along with the factory in Farmington, was sold in December for about $3 million to New York-based 22nd Century Group Inc., which is developing low-nicotine cigarettes. The latest plan to resolve the final claims would establish a trust controlled by the states that would get all the escrow money, now about $47 million. (Last month, Phelps, representing himself, filed a stay to the proceedings.) The states would use $10.5 million to pay off other creditors and keep the rest, with no need to file a claim to gain access to these funds. Tourtellot says that may have been NAAG’s goal all along. “I think hindsight would tell you that.” NAAG declined to comment.

On March 30 of this year, Phelps was sentenced to 40 months in federal prison, which he is serving at Federal Correctional Institution Beckley in Beaver, W.Va. He must also pay restitution of $5.1 million to NAAG. Lisa Phelps lives in Mocksville. Her attorney, Gray Wilson, says in an email: “In the approximate five years I have been privileged to represent them, I have found them to be wonderful people victimized by this litigation, and I know that when all of this is over, the Phelpses will still be together as a family, and that they have much to offer in the future.” More than a dozen of Calvin Phelps’ friends and co-workers wrote letters to the judge in the criminal case, urging leniency. They cited his generosity, strong faith and role as a father to his two young children. Almost all declined to comment beyond their statements.

The exception was Evan Slater, who is Phelps’ first cousin and was an usher at his wedding. He ended up working at Renegade as a property manager and jack-of-all trades for $55,000 a year. He says he was the last person to leave the company when the doors closed and is still grieved by what happened. Phelps, Slater says, was brought down by Big Tobacco and bad advice. Publicly traded 22nd Century Group is in the process of reopening the factory. It too wants to be a player, running with the majors and trying to navigate the maze of rules and regulations required to sell tobacco products. Slater has thought about applying for a job, but he’s not sure he’s ready to walk through the doors again. “I don’t know if I can go back there. It’s still heavy on my heart.”

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