SEC Charges Thornburg Mortgage Executives with Financial Fraud
Perhaps the SEC, at least for the time being, is finding its groove with respect to financial fraud matters. For the second time in a two-month span, the Commission has brought a case for fraudulent disclosures regarding the health of a residential loan portfolio. In January, the SEC filed suit against Florida-based BankAtlantic and its CEO. On March 13, the SEC charged three executives of Thornburg Mortgage Inc. – once the nation’s second largest independent mortgage company after Countrywide – with misrepresenting the company’s financial health in the wake of the recent credit crisis. Thornburg declared bankruptcy in 2009 and was not named as a defendant. But CEO Larry Goldstone, CFO Clarence Simmons, and chief accounting officer Jane Starrett were named. As always with litigated matters on Cady Bar the Door, the facts that follow come from the SEC’s complaint, have not been proven, and may not be true.
Background
As a real estate investment trust, Thornburg was unable to retain most of its earnings because it was required to pay them out as dividends. So, to finance its mortgage business, Thornburg needed constant access to financing, which included money borrowed from various lenders under reverse repurchase (or, “repo”) agreements. These repo agreements typically consisted of a sale of adjustable-rate mortgage (“ARM”) securities to a lender at an agreed price in return for Thornburg’s agreement to repurchase the same securities in the future at a higher price. The repo agreements required Thornburg to maintain a degree of liquidity and subjected the company to margin calls if the value of its securities serving as collateral fell below designated thresholds.
Trouble Hits in August 2007 and Doesn’t Let Up
In August 2007, Thornburg ran into some financial difficulty. Though the company received margin calls from its lenders in the normal course of its business due to fluctuations in the value of its ARM securities, that month the margin calls reached unprecedented levels. In response to roughly $2 billion in margin calls, Thornburg sold nearly $22 billion of its mortgage-backed securities at an estimated loss of $1.1 billion and decided to forego a common stock dividend for the third quarter. Margin call issues continued in the fourth quarter of 2007, and Thornburg paid approximately $360 million in margin calls in the last two months of the year. Thornburg’s financial condition and liquidity worsened in January and February 2008 as a result of ongoing turmoil in the financial and mortgage markets. The company met about $650 million in newly issued margin calls from its lenders.
As a result of its severely compromised liquidity, Thornbug was not in a position to timely meet the $300 million in margin calls it received in the last two weeks of February 2008, just before filing its 2007 10-K. The company was consequently in violation of its lending agreements with at least three lenders. Unwilling to disclose these late payments or the severity of the company’s liquidity crisis, Goldstone, Simmons, and Starrett scrambled to satisfy all outstanding margin calls before filing Thornburg’s 10-K at the end of February, according to the complaint. One of its strategies allegedly was to sell the interest-only portions of its securitized ARM loans (“I/O strip transactions”) to generate sufficient cash to meet its margin calls during the last week of February. These sales were significant because they further depleted Thornburg’s liquidity to meet margin calls and called into question the company’s ability to hold its ARM securities to maturity.
The company’s plan allegedly then became this: file the 10-K as early as possible on the morning of February 28, be able to say in that document that the company had “successfully” met all of its margin calls as of that moment, and hope for the best. It didn’t work out. The 10-K was filed at 4 a.m., and additional margin calls flooded in from Thornburg’s lenders two hours later. The company’s available liquidity was exhausted by 7:30 a.m. Two business days later, Thornburg filed an 8-K announcing that it had incurred an additional $270 million in margin calls, and that it did not have sufficient liquidity to satisfy the substantial majority of them. Another 8-K followed on March 5, disclosing that a lender issuing a notice of default was exercising its rights to the securities serving as collateral under its repo agreement due to Thornburg’s failure to meet its $28 million margin call. The company filed yet another 8-K on March 7, stating that it had incurred over $1.77 billion in margin calls since the first of the year, and that it did not have enough cash to cover $610 million of those. And Thornburg would also be restating its 2007 financials to recognize an impairment charge of $427 million in unrealized losses associated with its ARM securities.
Audit Issues
In connection with Thornburg’s 2007 year-end audit, the company was required to analyze whether it had the intent and ability to hold its ARM securities to maturity or until their value recovered in the market. If Thornburg truly planned to hold the securities to maturity, any losses associated with them were deemed to be temporary and only needed to be reflected on the company’s balance sheet. If Thornburg could not hold them to maturity, the losses were deemed to be other than temporary, and Statement of Financial Accounting Standards No. 115 required the losses to be reflected in the company’s income statement as well.
This analysis is called an other-than-temporary impairment (or, OTTI) analysis. The SEC charges that Thornburg’s executives failed to consider all of the critical information in connection with their OTTI analysis of the company’s ARM securities and misrepresented or concealed this from Thornburg’s outside auditor. When the outside audit manager specifically asked about any contractual breaches or noncompliance issues, the defendants failed to disclose Thornburg’s violation of its lending agreements. In sum, the executives knew, or were reckless in not knowing, that the losses associated with the company’s ARM securities were other than temporary, but told its outside auditor and public investors otherwise.
Claims
The SEC charged all of the defendants with (1) violations of Sections 10(b), 13(b)(2), and 13(b)(5) of the Exchange Act, (2) aiding and abetting Thornburg’s violations of Section 10(b) and 13(a) of the Exchange Act, and Rules 12b-20 and 13a-1 thereunder, (3) violations of Section 17(a) of the Securities Act, and (4) violations of Rule 13b2-2 under the Exchange Act. The complaint also charges Goldstone and Simmons with control person liability under Section 20(a) of the Exchange Act for Thornburg’s violations of Sections 10(b), 13(a), and 13(b)(2) of that Act.
Interesting Facets of the Case
A number of features about this case leap out at me. First, the 10-K as Thornburg filed it at 4:00 a.m. on February 28, 2008, was in large measure technically true. The company had met all of its margin calls. It appears that the defendants knew that disaster was right around the corner – and it was – but as of the filing of the 10-K, the statements about Thornburg having met its margin calls were true. In the press release, Don Hoerl of the SEC’s Denver Regional Office calls the 10-K “disingenuous” because it is hard to say flatly that it was false. To be fair, the complaint also alleges that the 10-K’s statement that Thornburg had not sold any assets to meet margin calls was not true without further statements making the I/O strip transactions clear. Second, any misrepresentations in the 10-K were essentially corrected by March 7, 2008, the date of the last of the follow-on 8-Ks. That is an extremely compressed time period, much more so than the two quarters of alleged misstatements in the recent BankAtlantic case.
But misrepresentations are misrepresentations, and the SEC is not tolerating them here. Finally, the SEC has likely charged the Goldstone and Simmons alternatively as control persons because of lingering concerns from last summer’s Janus Capital Group(link is external) decision from the Supreme Court. Rather than worry about amending the complaint if the district court ultimately decides that those two did not “make” the statements attributable to the company in the 10-K, the Commission has gone ahead and foreclosed the possibility of dismissal on that basis by naming them as control persons. It is probably a smart move. Again, the facts of this case have not yet been proven, and may not be true, but it will be interesting to see what happens as it progresses.