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STRATEGY

Train Wreck
 

Mike Wolf always dreamed of running toy-train icon Lionel. Now he's locked in a death struggle with the company he loved. A report from model railroading's trial of the century.
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One moment it was business as usual for mike wolf. The next, with a ring of the phone in 1999, everything changed.

"Mike, we just got the Lionel C&O Alleghenys," the hobby shop dealer told him. "And, man, this thing looks just like yours."

Wolf rushed to the hobby shop, reached for the new $1,399.95 die-cast O-scale engine, and confronted an entrepreneur's nightmare. Gone were the small imperfections in the metal casting that Lionel buyers had learned to live with. The details on the engine that Wolf turned over in his hands were uncharacteristically sharp and crisp. And to Wolf, founder and owner of MTH Electric Trains, they were all too familiar.

"It is just like ours," he realized with a sick feeling. Lionel, he thought, had gotten too good, too fast. "No way they built this without something from us." The implications rushed at him like a roaring locomotive.

Model railroading sells a kind of gauzy, nostalgic innocence, but people in the business have always played rough. The industry's legendary founder, Joshua Lionel Cowen, pulled few punches in battling his rivals of the day, A.C. Gilbert and the Ives Co. A 5-foot-5-inch titan of American entrepreneurship, Cowen founded Lionel Manufacturing in 1900 at age 23. A master marketer and a fierce competitor, he positioned trains as the ultimate feel-good father-son bonding hobby while at the same time savaging every other train company with no-holds-barred advertising.

By 1953, annual revenue had reached $32 million and Lionel had become one of America's most beloved and recognized brands. Tougher times befell Lionel in the '60s, however, when it shrank to a holding company that leased its name to the toy division of General Mills. Cheaper trains and a disastrous relocation of production facilities to Mexico followed, moves that alienated longtime customers and opened the door for a small niche player called Williams Reproductions to manufacture tin plate reproductions of old, discontinued Lionel models.

Williams Reproductions, which operated out of the basement of the Laurel, Md., home of a part-time enthusiast named Jerry Williams, paid neighborhood kids $1.50 an hour to assemble engines and passenger and freight cars, which Williams then sold through hobby shops and train shows. Among the first wave of boys who hammered rivets and painted trim lines was Mike Wolf, who started at age 12 in 1973 and has been in the business ever since.

Wolf first saw his life's work stretch out in front of him in 1977, the day Williams enlisted his help at the York, Pa., train show, the biggest on the railroading calendar. Hobbyists flock there to talk, to see the latest models, to fill the trunks of their cars with engines and boxcars and accessories. Williams positioned Wolf behind the parts table, where the line often snaked practically out of sight. Wolf, who got to keep 10% of the take, remembers selling $150,000 worth of parts at a single weekend show.

The industry counts on two sometimes overlapping breeds of train buyers: modelers and collectors. Modelers are the guys who toil for hours on end over their basement layouts. Collectors are more likely to have a wall display of engines as well as engines and cars untouched in their original boxes. Modelers typically work in HO-scale, while collectors tend to focus on O-scale, which, at one-48th the size of an actual train, is twice the size of HO. For manufacturers, the money is in O-scale. An HO engine might cost up to $100, depending on the manufacturer; O-scale engines start around $300 and can rise to several times as much.

Wolf started his own business as a teenager. With his mentor's permission, he sold Williams's trains and parts via mail order from his bedroom, taking phone orders from the West Coast late at night, processing credit-card transactions, and maintaining a customer database on an early Apple. He called the company Mike's Train House -- later renaming it MTH Electric Trains as he moved to more spacious office and warehouse quarters in Columbia, Md. His catalog was crude. He slept each night surrounded by boxes of inventory. And he arranged an unusual pickup system with the UPS man in order to keep the shipments moving while he attended classes at a nearby community college. He parked an unlocked Ford Falcon in front of his house as his mailbox. A red rag on the antenna signaled a pickup. There were plenty. It wasn't long before Wolf became Williams' largest distributor.

When Williams decided in the mid-'80s to sell part of his business, Wolf was his buyer of choice. At age 22, a year younger than Joshua Lionel Cowen had been when he founded Lionel, Wolf was becoming a player in the industry. In fact, he was something of a second coming of Cowen. Wolf, too, topped out at 5-foot-5. And he would prove just as competitive, self-promoting, and audacious as the man he considered his role model. For a time, all MTH people wore black shirts at train shows. "So we were known as the men in black, the bad guys," Wolf says. "How else could I get Mike's Train House to outsell Lionel? People have to notice us to find out ours is a better product, so we did a lot of in-your-face advertising." In 2002, Classic Toy Trains magazine named Wolf the most influential person in the industry in the previous 15 years.

On that day in 1999 when he realized that Lionel was bearing down on him with a vastly -- and to his eyes, suspiciously -- improved product, Mike Wolf wasted no time responding. Sales at MTH were headed to a high of some $60 million in 2000, close to Lionel's industry-leading position. Wolf had closed the gap by offering innovative products and lower prices, but most important, he made better trains. If Lionel was now matching his quality, he faced trouble. He knew only too well the power of the nearly century-old brand -- especially among men going gray and bald, men for whom the name Lionel was a ticket back to childhood.

Wolf showed the suspect Lionel engine to his top managers, all childhood friends, many of whom also had worked in Jerry Williams's basement. They backed his decision to board a plane for South Korea and try to jump-start an investigation at his design and manufacturing subcontractor, a company called Samhongsa. Like a lot of companies, MTH had reached a certain size and realized that irresistible advantages lay in moving manufacturing overseas. It had some downsides, but in 15 years Wolf had never had reason to worry that the company's proprietary design drawings and tooling were half a world away, under someone else's control. Now he realized how vulnerable he'd become.

When he hit the ground in South Korea, however, he did benefit from prompt and diligent attention from both his Asian business partner and South Korean authorities. Investigations pinpointed a former designer of MTH trains at Samhongsa who had moved on to become chief engineer at a rival company called Korea Brass. The former designer confessed to receiving stolen MTH designs on computer disks from accomplices at Samhongsa. It was a thoroughly modern theft: Before computer design, a single die-cast train engine might have required more than 200 desktop-covering drawings, and copies would have been as easy to sneak out the door as a rolled-up throw rug. Nowadays that amount of digitized information can fit on a USB flash drive, the sort of thing people carry on key chains.

"The irony of trade-secret theft is that your entire company can be stolen over the weekend, and you come in on Monday and everything's still there."

"The irony of trade-secret theft," says R. Mark Halligan, a lawyer with Welsh & Katz in Chicago and a professor in trade-secret law at the John Marshall School of Law, "is that your entire company can be stolen over the weekend, and you come in on Monday morning and everything's still there. Somebody simply downloads your entire hard drive."

Samhongsa's former designer was convicted of trade-secret theft, as was the head of Korea Brass, who was found by a South Korean appellate court to have paid for the stolen designs and used them in the manufacture of trains it sold to Lionel. (A total of four people were convicted. The harshest sentence was a jail term of several months.) The link to Lionel was a U.S.-based Korea Brass sales agent named Yoo Chan Yang, who happened to be in South Korea the day of a February 2000 raid of Korea Brass' office and whose computer Korean agents seized. Yang's hard drive contained e-mail correspondence with a high-level Lionel employee that pointed to Lionel as a knowing recipient of the stolen designs and some of MTH's production schedules as well.

By any reckoning, those were smoking guns. When Wolf tried to interest the U.S. Department of Justice in prosecuting the case under the Economic Espionage Act of 1996, however, he got an ear, but no action. "The act can be a powerful tool, but it's judicial discretion," says Halligan. "I have taken half a dozen trade-secret cases to the FBI. Not one has been to the courtroom." Prosecutions are rare in part because of 9/11-altered priorities and resources and in part because there are bigger corporate fish to fry. Halligan's monitoring of trade-secret cases indicates a bit more than 50 instances of charges being brought in the nine years since the act's inception, generally in cases that tend to be slam dunks. And prosecuting Lionel would not be easy. Not only had the evidence trail begun on the other side of the globe, but it would involve putting an icon on trial -- not quite on the order of prosecuting Santa Claus, as in Miracle on 34th Street, but surely not a case coveted by prosecutors with political ambitions.

Nonetheless, Wolf wanted Lionel brought to justice. In truth, he wanted more. He wanted Lionel brought to its knees. He was fighting for the survival of his company and also for a measure of revenge. He had for a time maintained a partnership with Lionel, had even thought he might one day run the company, and now the competition between MTH and Lionel was bitter in a way that perhaps only relations between former partners can be. In the spring of 2000, Wolf brought a civil action against Lionel, seeking $29 million in damages for misappropriation of trade secrets. The suit also named Korea Brass and Yoo Chan Yang as defendants.

The industry was aghast. "It's the O.J. Simpson case of the model-railroad industry," says Fred Hamilton, executive director of the Model Railroad Industry Association, a trade group. "Everybody's supposed to be doing it for fun -- nobody's supposed to be mad at anyone else, nobody's supposed to sue anybody else. It's a hobby."

"If you want to get Freudian, this is the boy seeking to slay the father."

Ron Hollander, author of All Aboard: The Story of Joshua Lionel Cowen & His Lionel Train Company, offers another metaphor. "If you want to get Freudian," he says, "this is the boy seeking to slay the father. What would be the ultimate train empire for Mike Wolf? To supplant and replace Lionel." Indeed, Wolf has said that he'd like to own or run the company that remains synonymous with what aficionados call the World's Greatest Hobby. Had things played out differently back in the late '80s and early '90s, he might already have accomplished that goal.

Back then, he'd actually hitched his business to Lionel. In the mid-'80s, Lionel decided to resurrect its old tin plate designs. It approached MTH's manufacturer, Samhongsa. "They wanted my supplier to dump me," says Wolf. But Samhongsa stuck by him, alerted him to the incursion, and told Lionel it would deal with the company only through MTH. Lionel eventually came around and welcomed Wolf aboard in 1987. "We started building 100% of what they called at the time Lionel Classics," Wolf says. "They'd never built their reproductions before. We were painting and assembling them here in Maryland at the beginning; then the volume grew too big and we transferred that to Samhongsa."

Wolf wrote to his customers, explaining the new order of business. MTH was now a subcontractor making trains for Lionel and had stopped making trains under its own name. And, as part of the deal, Wolf's company became a Lionel distributor, selling all models of Lionel trains. Wolf traveled frequently to Lionel headquarters in Chesterfield, Mich., and began taking part in product and marketing discussions. He says he felt "almost like an employee" at the company that first put electric trains under the Christmas tree.

For a time Wolf had a close relationship with Lionel's then-owner, a Michigan businessman and train enthusiast named Richard Kughn, who had acquired Lionel in 1986 from General Mills. According to Wolf, Kughn sought his advice on marketing decisions and running the business -- and received Wolf's very straight answers. Kughn, who declined to comment, apparently didn't care for much of Wolf's advice -- as when Wolf told Kughn that Lionel's ranks included a lot of deadwood that needed to be cleared. Subtlety has never been Wolf's strongest suit. "I guess it's one of my downfalls," he says. "I'll tell you what I think and tell you how I feel. If you don't like it, at least we know."

A deteriorating situation became unfixable in April 1993 at the York train show. The catalyst: Kughn spotted a new MTH brochure announcing the planned production of an O-scale plastic diesel engine called the Dash-8. Pulling Wolf aside, he asked angrily if MTH indeed planned to go into direct competition with Lionel with that engine. Indeed it did.

Lionel responded decisively. It terminated MTH's distributor status -- Wolf says he was then the second-largest mover of Lionel trains and parts in the nation, selling $3 million to $4 million of Lionel products annually -- cutting off delivery right then and there. "I had $750,000 worth of pre-orders and had taken deposits from customers," says Wolf. Lionel's response? It would fill the orders. "With my mailing list? No way," says Wolf.

Why had Wolf decided to compete with Lionel? "The Dash-8 came about because they weren't giving me any more orders [for reproductions]," he says. Plus, he says, he'd first offered to build this more expensive, more difficult-to-manufacture diesel engine for Lionel. Those things may be true, but Wolf was not entirely forthcoming with Lionel on another matter: He had become a hidden 50% partner in a start-up called Weaver Brass that built and sold brass O-scale steam engines. Wolf was competing against Lionel at the same time he worked for it.

After the blowup, Wolf returned his customers' deposit money and filed an antitrust suit against Lionel, accusing it of trying to run him out of business. The suit dragged on, blocking Kughn's attempts to sell his controlling interest in Lionel. Says Jim Bunte, a former Lionel vice president: "I don't think Mike intended to split off and do his own thing. He faced what I faced when I went to work at Lionel -- a very entrenched bureaucracy. Mike's a very entrepreneurial guy. He's been fueled over the last 10 to 15 years out of a sense of vengeance. He feels he was wronged by Kughn.

"Mike is not sparkling lily white in all this," Bunte continues. "But he has a lot of fans. A lot of people love the fact that he pushed the product in a scalelike direction, dragging Lionel away from its kind of toylike past. They like the innovation that Mike brought. And a lot of these guys are underdog worshippers. They like the underdog kicking the big guy in the nuts."

More than two years later, in 1995, the companies finally settled out of court, and Lionel was purchased by investor Martin S. Davis, who received a 75% stake, and rock star Neil Young, who got 20%. Davis, the former head of Gulf+Western, has since passed away, and the company is now managed for his heirs by Wellspring Capital Management, a New York City-based private-equity firm. The settlement did nothing to curb the animosity. And Lionel was clearly vulnerable. An internal memo noted: "Prior to Wellspring's purchase of Lionel, the company had not invested substantially in new tooling, and had no ability to do so. The company had no internal electronics ability, inadequate vendors for major components, and an understaffed engineering department. As a result, Lionel was saddled with an aging and unreliable product line at a time when competitors were improving their offerings."

Wolf, emulating his hero, Joshua Lionel Cowen, rattled the industry with a barrage of aggressive comparative ads -- and a provocative demonstration at the next York train show. MTH arrived with a display featuring an uphill stretch of track used for a demo that repeated again and again throughout the weekend. An MTH engine pulled a Lionel engine backward up the hill, while the Lionel's wheels spun pitifully. Near the top of the hill the MTH engine hit a sensor that cut the power. The coupled engines slid back downhill, and the Lionel engine smashed into a bumper, symbolically adding insult to injury.

In a federal courtroom in Detroit in May 2004, a jury of six women and two men got a glimpse of just how personal things had grown when MTH's counsel quoted an e-mail from Korea Brass agent Yoo Chan Yang to former Lionel director of engineering Bob Grubba that referred to MTH as "the dirty rat." Another e-mail from Yang to Grubba said: "By the time MTH realizes what is happening, the game should be over...We know exactly what the other camp is doing."

Wolf took the witness stand a week into the proceedings. By then, he'd been away from his business for 10 days, holed up with his lawyers from early morning till late at night. The physical toll was clearly visible in the bags under his eyes. He knew, however, that he was fortunate to be making his case to this jury. Most small businesses wouldn't have made it this far in a civil theft-of-trade-secrets case against a much more established competitor with deeper pockets. At the time of the trial, Wolf estimated his legal expenses, ratcheted nastily upward by its foreign components, were approaching $4 million, with more than $1 million already out of pocket. He was able to continue only because his law firm felt confident enough of the outcome to work on contingency.

The jurors heard of Wolf's rise in the world of model railroading and saw a slide of his family's modest Cape Cod-style house, including the window of the upstairs bedroom where Mike's Train House was born. They heard him testify about the impact not just of the theft of his designs but also of the theft of his production schedule, which his lawyers had shown had ended up in the hands of Lionel's president and other top employees. "It's easy to beat your competition when you know what they're making and how many they're making," says Wolf. "It's like shooting fish in a barrel."

To press his case, Wolf felt compelled to reveal much of his privately held company's production strategy and financial information. He testified that MTH made $9.6 million in profit in 1997. The number dropped to $7.8 million in 1998, $6.2 million in 1999, and less than $1 million in 2000 -- as Lionel, he testified, competed with him model by model, using his own drawings to flood the market, intent on putting him out of business. Wolf told the jury his company lost some $815,000 in 2001 -- one of many revelations he found painful. "This is the way the system works," Wolf said back at his hotel after his second day of testimony. "It's like a woman who gets raped and then has to explain her sex life in court." And then the transcript is easily ordered, nowadays on CD, by the rest of one's competition.

Two weeks after the trial started, after deliberating for parts of two days, the jury returned, having completed a seven-question verdict form:

Was plaintiff the owner or co-owner of information that qualified as a trade secret? Yes.

Did defendant Korea Brass and defendant Yang improperly acquire, disclose to Lionel, or use this information? Yes.

Did defendant Lionel improperly acquire or use this information? Again, Yes.

Did improper use of this information cause injury to Mike's Train House's business? Yes.

Then the court clerk came to question five on the verdict form -- the amount of damages the jury chose to award MTH for past lost profits and future lost profits. For past: "Eleven thousand, nine hundred...." The clerk stopped and corrected herself: "Eleven million, nine hundred and seventy-eight thousand, eight hundred and eighty-seven dollars." For future profits: $13,794,518.

In addition, the jury deemed that Lionel had unjustly enriched itself by $12,834,820 and Korea Brass and Yoo Chan Yang by $2,167,440. Lastly, the jury answered once more in the affirmative: Yes, the defendants' actions were willful and malicious.

Wolf's head was down; he was totaling the numbers he had written down. When he looked up from his sheet of paper and a number in excess of $40 million, he turned to the jury and mouthed the words: "Thank you."

While Lionel and Wellspring have mostly declined to comment on the trial, juror Edward Rutkowski, a 51-year-old tooling layout inspector and the only member of the jury with relevant technical manufacturing expertise, explained one of the determining factors. "What was pretty damning," he says, "we brought into the jury room two trains [an MTH and a Lionel]. I flipped them over and the way the screw holes and everything lined up there was no doubt in my estimation that it was a copied design. You could have literally screwed the parts for one train to the other."

After news of the verdict was reported in the Detroit papers and The Washington Post, which serves MTH's hometown of Columbia, Wolf's phone started ringing with calls from stockbrokers and insurance salesmen and financial planners. But there's been no windfall. And, except for a brief, call-all-the-employees-together meeting, no celebration to speak of.

It took U.S. District Judge John Corbett O'Meara, who presided over the case, nearly five months to issue his final ruling. He did so in early November, at which time he denied all of Lionel's post-trial motions, including an ongoing request that the verdict be dismissed for lack of evidence. He let stand the damages assessed by the jury. Furthermore, O'Meara enjoined Lionel from using existing tooling or drawings to continue to manufacture the 20 engines that the jury determined Lionel had manufactured through the misappropriation of MTH trade secrets.

In the time between the jury's decision and the judge's final ruling, Wellspring fired Bill Bracy, Lionel's CEO and president, and installed Jerry Calabrese, former president of the company that owns Marvel Comics -- making him the sixth Lionel president in 15 years. It was Calabrese, then, who led Lionel on November 15 as the company filed for protection under Chapter 11 of the U.S. Bankruptcy Code.

As Lionel made its filing, Calabrese released this statement: "The MTH judgment alone has forced us to take this action. Lionel is a sound company that enjoys healthy sales, growing demand for our products and the best brand and reputation in the business. Having said that, the size and weight of this judgment is just too much for what is essentially a small business to bear. Taking advantage of bankruptcy protection will not only allow us to pursue an eventual reversal of this unfair decision, it will enable us to create, manufacture and ship our products in our normal and usual way."

Those last four words, especially, stuck in Wolf's craw. "They have yet to accept responsibility or redress their actions, which the jury found to be willful and malicious," he says. "And in their press release they proudly claim business as usual. I've been vindicated on paper, but I've not received a dollar -- I've had to cut back to sustain my business."

Where this will end isn't clear. MTH is Lionel's largest unsecured creditor -- and will have a say in any reorganization. There is a chance that Wolf really will come to own Lionel, or at least rights to the trademark. But there are other scenarios, some of which involve the loser of a devastating trade-secrets judgment outlasting the winner. Lionel is pressing for a reversal or downsizing of the jury verdict -- and could, of course, prevail on appeal.

These days, MTH's 120,000-square-foot building, which once received and processed nearly 200 container loads of trains made in South Korea and China annually, is unloading two-thirds as many. From a high of 127 employees, MTH is down to 57. Unoccupied desks make some departments look like ghost towns. Nobody has gotten a raise or a bonus in four years. Wolf says he's cut his own salary from $195,000 to $35,000 a year and has sold off much of his personal train collection. Sales are down to about half their peak from five years ago, as demand in the O-scale market has shrunk. Blame the economy, but also blame overproduction fostered by the poisonous competition between MTH and Lionel. MTH made a five-figure profit in 2003. The expectation for 2004? "We're going to lose six figures," says Wolf.

And yet, he also says he'd file the suit all over again -- regardless of the price he's had to pay and how consuming it's been. Even when he's at home in his own backyard, Mike Wolf, who has been in the business of model trains for more years than he's been shaving, cannot get away from this industry train wreck. At least not if he's facing his house, which he built back when he worked with, not against, the company founded by Joshua Lionel Cowen. For there, bricked into the chimney, like a tattoo bearing the name of a former girlfriend, appear a half-dozen foot-high letters:

L-I-O-N-E-L.

John Grossmann, who wrote about Cobalt Boats in Inc.'s August 2004 issue, can be reached at trainwreck@inc.com.

Last updated: Feb 1, 2005




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