A Potentially Significant Financial Fraud Case

In congressional testimony last month, SEC Commissioner Elisse B. Walter outlined the current investigative efforts of the enforcement division relating to the market crisis. Part of those efforts focus on accounting and disclosure issues of subprime lenders and major financial institutions. The issues concern improper accounting for loan loss reserves, the impairment of asset values, disclosures regarding loan quality and credit risks and the understatement of delinquency rates. Elisse B. Walter, Testimony Concerning Securities Law Enforcement in the Current Financial Crisis, March 20, 2009 before the House Committee on Financial Services.

SEC v. Strauss, Civil Action No. 09 CIV 4150 (S.D.N.Y. Filed April 28, 2009) is a significant financial fraud case because it may be a harbinger of cases to come from the market crisis investigations. The defendants in Strauss are Michael Strauss, formerly the chairman, CEO and president of American Home Mortgage Investment Corp.; Stephen Hozie, former EVP and CFO; and Robert Bernstein, former EVP and controller of the company.

American Home Mortgage, under the leadership of the defendants, reported profits every quarter following its IPO in 1999. By 2006, the company had originated billions of dollars of mortgages. The company also held mortgage backed securities as interest generating investments. During this period, American Home Mortgage enjoyed a reputation as a successful and fast growing company — until it filed for bankruptcy in August 2007.

Growth of the company came in part by originating mortgages without verifying the income of the borrowers. Specifically, by December 31, 2006 for over 60% of the mortgages originated the company did not verify the income of the borrower. This exposed American Home Mortgage to serious liquidity problems as the rate of defaults accelerated in early 2007. Deteriorating market conditions in the first quarter of 2007 left the company with an increasingly large portfolio of loans for sale. Indeed, between December 31, 2006 and March 31, 2007 the dollar amount of loans being held for sale tripled from about $1.5 billion to $4.8 billion.

As losses mounted for the first quarter of 2007, the need for additions to the loan loss reserve were analyzed. If the necessary amount was added to the reserves, defendants Strauss and Hozie knew, according to the SEC, that the company would report its first quarterly loss. To avoid this result, additions were made but they were inadequate. This converted a loss into a profit. The results were reported in the Form 10-Q — a false filing for the quarter.

To conceal the actual results and the fraud, defendants Strauss and Hozie also: 1) made misleading disclosures about the company’s loans which concealed its exposure to loss; 2) failed to disclose that most of its mortgage backed securities were sold in April 2007; and 3) misled investors about the cash position of the company in its first quarter earnings call and the 10-Q. Defendants Hozie and Bernstein also misled the outside auditors in connection with their review of the quarterly results and filing. All three defendants are alleged to have falsified the books and records of the company and to have circumvented the internal controls.

In May 2007, the misrepresentations about the financial condition of the company were used in connection with the sale of 4 million shares of the company’s common stock to Citigroup. That sale, which raised about $90 million for the company, was based in part on the results stated in the first quarter 10-Q. In addition, defendants Hozie and Bernstein misled the outside auditors of the company

Mr. Strauss settled with the SEC at the time the complaint was filed. He consented to the entry of a permanent injunction prohibiting future violations of the antifraud, reporting, record-keeping and internal controls provision of the securities laws. He also agreed to pay $2.2 million in disgorgement and prejudgment interest and a $250,000 penalty and to be barred from serving as an officer or director for five years. Mr. Strauss had received about $3.5 million in compensation in 2006 and made a profit of about $2 million in 2007 following the liquidation of a margin loan collateralized by company stock.

The remaining two defendants are litigating the case with the Commission.