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.

Visions Of What May Come: A Glimpse Of The Future At The SEC

Recent speeches by SEC Chairman Mary Schapiro and Commissioner Luis Aguilar provide glimpses of the future at the SEC. In their remarks, the Commissioner’s commented on three key areas, enforcement approach and internal procedures, rule making initiatives and possible legislative proposals.

Ms. Schapiro, in her remarks to the American Business Editors and Writers on April 27, 2009, discussed the approach to enforcement, emphasizing that there is more than just a new division director. Rather, there is a new approach, a new tone at the top emphasizing speed, coordination and efficiency. That new tone begins with speeding up investigations, ensuring that the various staff divisions work effectively and that they coordinate with criminal authorities and state regulators. As part of this effort, Enforcement is considering unidentified “structural” changes that would make better use of its scarce resources.

Commissioner Aguilar, in his comments before the NASAA Members on April 28, 2009, titled “United in the Public Interest and Making Investors a Priority” added specific suggestions to improve enforcement. These include: 1) delegating authority to the Director of Enforcement and Heads of the Regional Offices to open routine, non-controversial formal investigations; 2) improving the collection processes to facilitate returns to investors; 3) implementing a risk-based data analysis system; and 4) revising the corporate penalty guidelines to focus on deterring misconduct. Commissioner Aguilar, like Chairman Schapiro, emphasized that “to revitalize its enforcement program, we must also continue to effectively coordinate” with others regulators.

Ms. Schapiro also outlined key areas for future rule making. One priority is rating agencies, where the Chairman stated that “the SEC needs to be pushing forward a real agenda of reform.” Next month, a key rule making initiative will be unveiled in the corporate governance area. These proposed rules will “remove the barriers that make it costly and difficult for a company’s owners to nominate directors.”

Another group of proposals will be issued for comment in June when the SEC will propose enhancements to the rules governing credit quality, maturity and liquidity provisions that apply to money market funds. These proposals are part of an overall review of rules applicable to these funds and echo the recent congressional testimony of the Treasury Secretary.

The Commission also intends to propose rules to strengthen the controls over investment advisers who have custody of investor assets. These proposals will include “consideration of ‘surprise’ examinations by a certified public accountant,” according to the Chairman.

Finally, when discussing legislative reform, Commissioner Aguilar focused on two key points. The first is to close the regulatory loopholes. This includes hedge funds and swaps which he termed “policy mistakes.”

The second turns on the question of regulation of systemic risk. Here, “the focus needs to be on ensuring the continuation of systemically important market functions, and on investor protections.” This means identifying systemically important market functions and ensuring that they are backed up properly so that if there is a failure by one entity, another can step in, the Commissioner noted. Accordingly, risk regulation would focus on overarching risk to the financial system. In this context, the SEC would continue to function as a primary regulator.