March 8, 2012

Delaware Joins States Changing Escheat Laws: A Sleeper

With states hungry for money, many have changed their escheat laws to make it easier for them to grab dormant accounts. This has been widely covered in the mass media (egs. ABC's Good Morning America; NPR's All Things Considered; UK's Tonight Show with Sir Trevor McDonald).

In our "Q&A Forum," we recently got a question (#7007) stating: "It appears the State of Delaware is re-interpreting "period of dormancy." We have discussed the new interpretation with Delaware and according to the Delaware State Escheator, "period of dormancy means the full and continuous period of time during which an owner has ceased, failed or neglected to exercise dominion of control over property or to assert a right of ownership or possession or to make presentment and demand for payment and satisfaction or to do any other act in relation to or concerning such property." That is, the statue requires that accounts for which shareholders have not exercised dominion, control or any other act related to the account for three years be turned over to the State of Delaware. As a result of this reinterpretation, several thousand shareholder accounts not considered "lost" under rule 17Ad-17 have now been identified as eligible for escheatment if contact cannot be established with the holder. What is going on here?"

Since this is not my area of expertise, I turned to Bill Palmer - who knows this stuff cold - who answered:

Clearly the State of Delaware is attempting to cast the net out as broadly as possible with its new interpretation, but there are more than a few problems with it. The Unclaimed Property Law (UPL) statutes first purpose is to reunite lost and unknown owners with their unclaimed property, and the secondary purpose is to allow the states an opportunity to make use of the property while the primary purpose is accomplished. As a result, starting with the opening definitions, the statutes require that the individual shareholder or owner actually be "lost" and "unknown" to the financial institution or holder.

A review of the statutes will show that the definition includes the requirement that the shareholder is "lost/unknown" and that the specific dormancy period has run. There's an important conjunction in the definition with the word "and," so to the extent that the individual is part of a dividend reinvestment plan, an ESPP, a custodial trust, or any number of scenarios, then it is not reasonable to conclude that the individual is "lost" and "unknown" for purposes of escheating their stock or assets to the various states. Based on the short note below, there are potentially serious statutory and constitutional issues regarding Delaware's new interpretation of escheat.

Another problem is created by the State of Delaware's approach is in the area of corporate liability, because it places the holder and its transfer agent in a difficult position vis-à-vis their common law and statutory duties to the shareholders or owners. The corporation is acts under common law, federal and state securities laws that require it to operate with the utmost care regarding the shareholder, and to convey material information to the shareholder. This is the dilemma created by Delaware's new definition, because "known" shareholders are about to have their stock transferred potentially without proper notice, where the investment will be sold and permanently destroyed so that the funds from the sale may be used by the state.

Mailed: January-February Issue of "The Corporate Counsel"

We mailed the January-February Issue of The Corporate Counsel and it includes pieces on:

- Mine Safety Disclosure Is Here--And The Forms They Are A-Changin'
- New Four-Month Deadline for Form 20-F
- Staff Weighs In on Say-on-Pay Wording on the Proxy Card/Voting Instruction Form
- Proxy Summaries
- Proxy Access Private Ordering (Barely) Up and Running
- NYSE About-Face on Shareholder-Friendly Governance Proposals
- The Staff's Waiver Position on Item 5.07 8-K/A Evolves
- Global Section 12(g) No-Action Relief for RSUs
- Trading in Securities of Pre-Public/Private Companies
- Loss Contingency Disclosures--Latest Input from the Staff
- The Staff Clarifies New Standards for Confidential IPO Filings for Foreign Private Issuers

Act Now: Get this issue for free when you try a 2012 No-Risk Trial today.

SEC Brings Increasingly Rare Financial Fraud Case

In his "Cady Bar the Door" blog, David Smyth of Brooks Pierce has been doing an excellent job and I've been learning a lot about SEC enforcement issues from reading his missives. Here's a recent one below:

A curious aspect of the SEC's enforcement program in recent years has been the lack of significant accounting fraud cases. The Enforcement Division has created a number of specialized units, including ones studying structured products and hedge funds, but dismantled its financial fraud task force in 2010, reasoning that accounting fraud was the specialty of the entire staff, and not just one group. Perhaps as a result of that, or maybe as a result of Sarbanes-Oxley or other reasons, accounting fraud cases just have not been brought in the numbers they were in years past.

But the SEC filed an interesting case last month in the Southern District of Florida, one that combines traditional accounting fraud with the problems underlying the most recent credit crisis. The Miami Regional Office sued BankAtlantic Bancorp and its CEO, Alan Levan, for making misrepresentations about the bank's loan portfolio and then using accounting tricks to conceal the misstatements. The case is not settled, so the facts that follow are unproven, and may not actually be true.

Disclosure Issues

In 2007, BankAtlantic had about $1.5 billion in its commercial residential real estate loan portfolio. The borrowers intended to develop large tracts of land for residential housing construction, and the portfolio included three types of loans: (1) Builder Land Bank loans, in which the borrowers' sole intent was to "flip" the raw land to a national builder at a later date. The bank usually required the borrower in one of these BLB loans to have option contracts in place in which the builder agreed to give a down payment and close on a minimum number of lots by a specific date; (2) Land Acquisition and Development (LAD) Loans, in which the borrower bought land and conducted "horizontal development" such as building utilities and roads; and (3) Land Acquisition, Development, and Construction (LADC) loans, which were the same as LAD loans, but also included financing for "vertical development," or houses, as well.

Signs of problems in BankAtlantic's commercial residential portfolio began to appear in early 2006. Builders were starting to walk away from their option contracts with BLB borrowers at other banks, and BankAtlantic started to scrutinize its own portfolio more closely. By the time BankAtlantic filed its first quarter 10-Q, the bank had granted extensions on eleven loans constituting a book value of $147 million, or 26% of the commercial residential portfolio. For most of these extensions sales had slowed or stopped, and borrowers were having to resort to entirely different development plans to salvage their projects. While these problems were affecting all three types of loans in the bank's commercial residential book, Levan didn't say as much publicly. In the bank's first quarter earnings call, Levan discussed the BLB segment and acknowledged that some problems were developing with the underlying projects. But when asked by an analyst whether the problems extended to the LAD and LADC loans, Levan said no, that those loans were "proceeding in the normal course" and the bank was experiencing no significant problems with them. The bank's 10-Q for that quarter discussed the commercial residential portfolio in board terms, but did not alert investors to the problems already existing at that time.

BankAtlantic's loans continued to be downgraded in the second quarter, and the value of the downgraded loans was nearly an even split between BLB and non-BLB loans. The second quarter earnings call continued the pattern from the first, as an analyst again asked if the bank was concerned about the non-BLB loans. Levan said again that the BLB side was the only one forecasting any problems. The 10-Q for that quarter also made no mention of any problems with the LAD and LADC loans, though those loans were having significant problems as well. BankAtlantic eventually released the extent of the bank's loan difficulties with an 8-K filed on October 26, 2007, that announced a $29 million loss due to the commercial residential loan portfolio. On the third quarter earnings call, Levan said the earnings release would have been very different if it had been done on September 30, 2007, suggesting that the problems were a surprise that came about after quarter-end.

Accounting Issues

This wasn't the end of BankAtlantic's problems, though. In the fourth quarter of 2007, the bank began efforts to sell many of its problem loans, and even engaged an investment bank, JMP Securities, in the effort. Unfortunately for the bank, the AICPA's Statement of Position 01-6 says that once a decision has been made to sell loans not previously classified as "held for sale," those loans should be transferred to the "held for sale" classification and carried on the books at the lower of cost or fair value. But that is not what BankAtlantic did. Instead, the bank changed its contract with JMP Securities to refer to the sales efforts as a "market test." At the end of 2007, the bank continued to record as held for investment the loans subject to the JMP engagement. The bank also represented to its auditor that "management had the intent and ability to hold loans classified as held-for-investment for the foreseeable future or until maturity or payoff." Meanwhile, JMP's efforts - to "sell" the loans or "test market" them or whatever - continued apace, and eventually some bids for the loans came in, all at 28-50% of book value.

BankAtlantic didn't like the bids enough to sell, but also did not like having the loans on the bank's books. So it made a deal to give an inactive subsidiary $100 million, which the subsidiary then gave back to the bank in exchange for the problem loans. For the bank, it was a perfect deal, in that it released the loans from BankAtlantic's books, and at the same time gave the bank an quick infusion of cash. JMP valued the loans for purposes of this transaction based on appraisals, and ignored the bids that came in at 28-50% of their book value. BankAtlantic continued to try to sell these loans, and even reached agreements to sell some of them, but never reclassified any of the loans as "held for sale."

The SEC has sued BankAtlantic for violations of Sections 10(b), 13(a), 13(b)(2)(A), and 13(b)(2)(B) of the Exchange Act, and Levan for aiding and abetting all of those violations. The Commission has also sued Levan for direct violations of Section 13(b)(5) of the Exchange Act.

Lessons from the Case

One thing we can learn from the matter is that accounting fraud is alive and well, and the SEC is still pursuing it. Also, publicly traded banks in particular should take note that the contents of their portfolios have to be characterized accurately, both in public statements to investors and with respect to accounting conventions established by the AICPA. If particular loans are being shopped to other buyers, you have to say as much, or you're out of compliance with GAAP, and are breaking the accounting rules. Finally, the public misstatements did not go on for a terribly long time. It was only two quarters before BankAtlantic owned up (sort of) to the problems on its books. But that was enough. The case is being litigated; it will be interesting to see what happens as it proceeds.

- Broc Romanek