Financial Services Alert - January 22, 2008

The significant turmoil in the mortgage markets is causing many in the industry to re-evaluate how to best engage in the lending business.  Stand alone mortgage lenders are finding it increasingly difficult to fulfill their important role of making home ownership a possibility for many Americans.  A primary source of this difficulty is the need for funding, as liquidity, namely loan sales, wholesale lines, and structured finance arrangements, have become extremely scarce.

As with all crises, these sources of funding will likely return, to a substantial extent, as the markets stabilize.  Nonetheless, certain mortgage lenders have expressed a desire to evaluate alternatives that could provide them with greater stability through the inevitable housing cycles.  In some cases, mortgage lenders have decided that affiliation with a bank or thrift institution, or conversion to a bank or thrift charter, may provide that stability.  In addition, banking organizations and financial services firms with special or limited purpose bank or thrift charters may be considering acquiring mortgage companies to obtain the relationships developed by the lenders and thereby increase their customer base. 

A number of Wall Street investment banks have acquired stand-alone mortgage origination platforms in the last few years, and Merrill Lynch, in 2006, obtained Office of Thrift Supervision approval to shift its mortgage business into an expanded, full service thrift institution.  This Alert article discusses some of the reasons behind these developments, including the greater access to liquidity sources that banking organizations enjoy and, for federally chartered institutions, the benefit of federal preemption of state laws.

To be clear, even though there are significant benefits to conducting a mortgage lending business through a bank or thrift charter that are discussed below, doing so is by no means a way to avoid regulation.  The banking industry is among the most highly regulated industries in the United States, and operating through a depository institution charter involves oversight from federal and, possibly, state banking regulators, depending on the charter type.  Banking organizations must also follow guidance from federal banking regulators that discourages origination of sub-prime loans and encourages thorough documentation and underwriting of prospective borrowers, and they need to support on-balance-sheet assets with appropriate levels of capital as well as to fulfill their obligations under the Community Reinvestment Act, among other requirements.  In addition, as a result of the sub-prime crisis and the effect of declining home values and broader economic uncertainty on foreclosure rates, Congress and federal and state regulators are very focused on the lending practices of all segments of the mortgage industry, including the banking organizations.  Furthermore, as recent earnings reports show, the banking industry is certainly not immune to broader economic turmoil.

Despite the highly regulated environment in which banking organizations operate, however, there are valid reasons for certain mortgage lenders to consider affiliation with a bank or thrift.  Conducting a mortgage business within a bank or thrift charter provides important advantages over a non-bank mortgage company platform, including, as described below, stability of funding and access to additional liquidity sources, the ability to offer customers a wider variety of products and services, and, for federally chartered entities, federal preemption of state laws.  Indeed, the following discussion is also relevant to a bank or thrift that is considering the acquisition of a mortgage company, as it highlights the benefits a depository institution can provide to the operations of such an institution.

Access to Funding.  With respect to funding, non-bank lenders rely chiefly on selling and securitizing loans and warehouse lines of credit to support originations, and those that hold loans or mortgage-backed securities for their portfolio also may turn to the asset-backed commercial paper markets as well as using reverse repurchase agreements to obtain funding.  Banks and thrifts also access these funding sources.  In addition, however, banks and thrifts can access funds through the ability to take insured deposits and obtain advances from the Federal Home Loan Bank System, the Fed Funds market and other sources.  For example, a bank or thrift can raise funds through issuing brokered certificates of deposit or through participating in a sweep program in which customers of an affiliated or even a nonaffiliated brokerage firm can sweep available cash balances in their brokerage accounts into insured deposits at the bank or thrift.  A depository institution that holds servicing rights could even potentially access cash by self depositing escrows for taxes and insurance payments.  And banks or thrifts that are members of the Federal Home Loan Bank System can pledge mortgage loans and mortgage-backed securities as collateral for funding advances.  Generally, it is not possible for a bank or thrift to transfer its access to additional liquidity to an affiliated mortgage lender due to affiliate transactions restrictions that apply to insured depository institutions.  However, conducting a mortgage business within the depository institution or an operating subsidiary of the institution avoids these limitations.

Access to Enhanced Customer Relationships.  Because it is possible to offer deposit and lending products and even fiduciary and asset management services within a bank or thrift charter, conducting a mortgage lending business through a banking organization or affiliation with a banking organization also provides an opportunity to offer customers a significantly wider range of products and services over time and to obtain a wider share of customers’ wallets and a more diverse revenue base to more easily weather downturns in the mortgage industry.  At the same time, mortgage lenders continue to be of interest to banks, because of the “stickiness” of their products as an opportunity to cross-sell a wide range of products and services to borrowers and prospective borrowers.

Affiliation Considerations.  For mortgage lenders and banks considering possible affiliation, the nature of the affiliation depends in part upon the scale of the mortgage business.  The March 5, 2002 Alert discussed the relative advantages and disadvantages of various charter types.  However, a more local mortgage company with a focus on a single market or a regional market that spans a few states might consider a state bank, where it is possible to develop a close relationship with a local regulator and where the advantages of federal preemption of state law are not as compelling. 

On the other hand, lenders with a larger network covering many states or the entire country would benefit from affiliation with a federally chartered entity because federal preemption of state law, which the Supreme Court most recently reaffirmed in the context of operating subsidiaries of national banks in its Watters vs. Wachovia Bank decision last spring, makes it possible to operate on a uniform basis in all markets.  In addition, a thrift charter is often an ideal vehicle through which to conduct a lending business focused on residential mortgage lending because thrifts have historically focused on mortgage lending and are able to operate branches nationwide with relatively few limitations.  As noted above, banks are themselves highly regulated and many industry observers expect that Congress and state legislatures will likely enact tougher limitations an all segments of mortgage lenders.  However, even if federal and state laws impose additional consumer protection requirements on the industry, it is likely that federally chartered entities will still have the benefit of operating under a single set of rules that applies nationwide.

Conclusion.  In sum, operating a mortgage origination business through a bank or thrift charter is an alternative worth considering for those mortgage lenders who are evaluating their options for weathering the current storm in the mortgage industry.  Affiliation with a bank or thrift charter is certainly not a practical or desirable option for lenders who focus on sub-prime lending and it may not be desirable for many mortgage lenders who are content to wait for the markets to return to normalcy.  However, conducting business through a depository institution charter may enable a mortgage lender to stabilize its operations and to focus more on the important business of home lending, and acquiring a mortgage platform may permit a depository institution to expand its reach to customers and provide additional opportunities to cross sell a wide range of products and services.

Goodwin Procter has assisted many nonbank financial services firms, including lenders, to evaluate whether a bank/thrift charter would be beneficial to their operations, and has assisted banks/thrifts to acquire nonbank operating companies.

In a 5-3 decision, the Supreme Court of the United States (the “Court”) held that private litigants could not pursue a suit under the anti-fraud provisions of Section 10(b) of the Securities Exchange Act of 1934, as amended, and Rule 10b-5 thereunder, against suppliers of cable boxes for their role in transactions with an issuer of publicly traded securities that issued misleading financial statements based on those transactions, which in turn affected the issuer’s stock price.  The Court’s decision followed a dismissal of the plaintiff’s complaint by the District Court on the grounds that it failed to state a claim on which relief could be granted; the United States Court of Appeals for the 8^th Circuit affirmed.  In its decision, the Court indicated that the Courts of Appeals were in conflict over whether an injured investor may sue under Section 10(b) to recover from a party that participates in a scheme that violates Section 10(b), even when the party does not make a public misstatement or violate a duty to disclose.

The Plaintiffs’ Allegations.  The plaintiffs alleged that the defendants and the issuer set up an arrangement where the issuer bought cable converter boxes from the defendant suppliers at a $20 premium over the usual price per unit with the understanding that the suppliers would use the amount of these overpayments to purchase advertising from the issuer.  The plaintiffs claimed that the transactions had no economic substance and were designed to allow the issuer to record the advertising purchases as revenue and capitalize its purchase of the cable boxes in violation of generally accepted accounting principles.  The complaint also alleged that the companies drafted documents to make the cable box and advertising transactions appear unrelated:  among other things, the agreements to purchase new cable boxes were backdated to make it appear they were negotiated a month before the advertising agreements.  The issuer recorded the advertising payments as revenue which was shown in financial statements filed with the SEC and reported to the public.  The amount of revenue recognized was approximately $17 million, which enabled the issuer to meet operating cash flow projections.  The defendant suppliers had no role in preparing or disseminating the issuer’s financial statements; their own financial statements showed the transactions as a wash in accordance with generally accepted accounting principles.  The plaintiffs alleged that the defendant suppliers (a) knew or were in reckless disregard of the issuer’s intention to use the transactions to inflate its revenues to make projections and (b) knew that the resulting financial statements for the issuer would be relied upon by research analysts and investors. 

The Court’s Decision.  The Court began its analysis by noting that under Central Bank of Denver, N.A. v. First Interstate Bank of Denver, N.A., 511 U.S. 164 (1994) (“Central Bank”), the implied private right of action under Section 10(b) did not extend to aiders and abettors; therefore, the conduct of secondary actors like the defendant suppliers must satisfy each of the elements for liability under Section 10(b).  The Court’s decision focused on the reliance element of Section 10(b) (the requirement that there be reliance on a defendant’s material misrepresentation or omission) and held that because the defendant suppliers had no duty to disclose and their deceptive acts were not communicated to the public (i.e., did not fall within the fraud‑on‑the‑market doctrine), the plaintiffs could not show reliance by the plaintiffs on any of the defendant suppliers’ actions except in an indirect chain that the Court found too remote to support liability.  The Court noted that nothing the defendant suppliers did made it necessary or inevitable that the issuer would record the cable box purchases and advertising revenue as it did.  In further support for its position, the Court cited its concern that construing Section 10(b) in the manner proposed by the plaintiffs, i.e., that investors relying not only upon public statements relating to a security, but also upon the transactions underlying those statements, would cause federal power under the guise of securities litigation to invade the realm of state law governing ordinary business operations.  The Court stated that although Section 10(b) is not limited to preserving the integrity of the securities markets, it does not reach all commercial transactions that are fraudulent and affect the price of a security in some attenuated way.  The Court also cited the Congressional response to Central Bank reflected in Section 104 of the Private Securities Litigation Reform Act which the Court viewed as reflecting Congress’ intention that aiders and abettors should be pursued by the SEC and not by private litigants.  Finally, the Court cited the practical concern that permitting the plaintiffs’ theory of liability under Section 10(b) would result in an expansion of securities litigation, which would raise the cost of doing business for U.S. issuers, deter overseas firms from doing business in the U.S. and shift securities offerings overseas.  Although it found the defendant suppliers were not subject to a private right of action under Section 10(b), the Court observed that secondary actors were still subject to criminal penalties, civil enforcement by the SEC and in some cases, state securities laws that permit state authorities to seek fines and restitution from aiders and abettors.  (Stoneridge Investment Partners, LLC v. Scientific-Atlanta, Inc., No. 06-43 (Jan. 15, 2008).)

Goodwin Procter’s Securities Litigation & SEC Enforcement Practice Area is preparing a Client Alert that discusses the Court’s decision and its ramifications in greater detail.  The Client Alert will be provided to Alert readers when it becomes available.

As previously announced, Goodwin Procter will host a free 90 minute webinar at noon (EST) on February 7, 2008 that will address the recent waves of ERISA litigation and related regulatory investigations – particularly those involving collective trusts and allegations of excessive fees charged by service providers, in addition to “stock drop” cases (as discussed in the December 25, 2007 and January 1, 2008 Alerts).

The CFTC’s Division of Clearing and Intermediary Oversight issued its annual guidance letter to registered commodity pool operators.  The letter is designed to provide guidance regarding the preparation and filing of commodity pool annual financial reports.  The letter is available on the CFTC's website here.

The SEC published the formal release adopting amendments to the proxy rules that address issues raised under the proxy rules by electronic shareholder forums.  The amendments are designed to clarify that participation in an electronic shareholder forum, which could potentially constitute a solicitation that requires compliance with applicable proxy rules, will be exempt from most of the proxy rules provided certain conditions are met.  Those conditions relate in part to the timing of communications by a participant in an electronic shareholder forum relative to the date announced by a company for its annual or special meeting of shareholders.  In addition, the amendments provide that a shareholder company or third party acting on behalf of a shareholder or a company, that establishes, maintains or operates an electronic shareholder forum will not be liable under the federal securities laws for any statement or information provided by another person participating in the forum.  The rule amendments will take effect 30 days after the adopting release is published in the Federal Register.