BANK OFFICERS TRY TO CONCEAL THE IMPACT OF THE FINANCIAL CRISIS

A financial fraud action was brought against former bank holding company CEO Anthony Nocella and CFO J. Russell McCann by the SEC. The action centers on the efforts of the two officers to conceal the true financial condition of Franklin Bank Corp. as the market crisis unfolded and its portfolio of real estate holdings unraveled. SEC v. Nocella, Case No. 4:12-cv-1051 (S.D. Tx. Filed April 6, 2012).

This is not the first action the Commission has filed against the officers of a financial institution who tried to conceal the deteriorating financial condition of their institution as the market crisis unfolded and took its toll. Prior actions include those brought against the officers of Countrywide Financial and UCBH. This may be the first however where the CEO and CFO tried to conceal the downward spiral of the institution’s loan portfolio and its finances by modifying the underlying loans to make them appear current when in fact they were not. As with prior schemes it failed.

The action centers on the efforts of Messrs. Nocella and McCann to prop-up Franklin Bank Corp., a Texas based savings and loan holding company. By the second quarter of 2007 the loan portfolio of the financial institution began to deteriorate as the financial crisis unraveled. During the summer of 2007 the two officers received reports that depicted a 24% increase in delinquencies in the loan portfolio compared to the prior three month period.

Despite its deteriorating financial condition, the two defendants were reviewing strategic alternatives which could include a sale of the bank. In August 2007 the two officers met with representatives of RBC Capital Markets. They were told that the institution needed to demonstrate positive earnings momentum to facilitate such alternatives.

Subsequently, Messrs. Nocella and McCann crafted three plans to improve the appearance of the loan portfolio and thus the operating results of the bank: Fresh Start, Strathmore Modifications and Great News. The first focused on bringing certain residential mortgages which were severely delinquent current by notifying the borrowers that if they made one payment, and agreed to certain other modifications, their loans would be considered current. Ultimately millions of dollars in loans were modified through this program to classify them current.

The second centered on the Strathmore Modifications. ThIS involved about $13.5 million involving four troubled loans to Strathmore Finance Company and its subsidiaries for construction projects in the Detroit area. By the summer of 2007 Strathmore could not repay the loans and requested a modification. The two defendants secured credit committee approval for a modification of the loans. In October 2007 the FDIC concluded after an examination that the loans should have been classified as “nonaccrual and evaluation for impairment” under the applicable GAAP provisions.

The third was the Great New program. It also involved the modification of residential real estate loans. This program involved 28 borrows who were severely delinquent, that is between 119 and 545 days past due. Under the program the borrowers only had to make the next payment to become current. Overall the loan modifications were not in accord with disclosed bank policies and GAAP.

The defendants’ schemes concealed from shareholders over $11 million in delinquent and non-performing single family residential loans and $13.5 million in non-performing residential construction loans, according to the complaint. Indeed, investors were falsely lead to believe that Franklin was outperforming other banks when in fact its financial condition was deteriorating. The programs did not save the institution. The bank ended in receivership and the holding company in bankruptcy in 2008.

The complaint alleges violations of Exchange Act Sections 10(b), 13(b)(2)(A), 13(b)(2)(B) and 13(b)(5). It seeks a permanent injunction, disgorgement, prejudgment interest, civil penalties, officer and director bars and repayment under SOX 304. The case is in litigation.