International Financial Law Prof Blog

Editor: William Byrnes
Texas A&M University
School of Law

Thursday, August 21, 2014

BOA's Securities Fraud Settlement with SEC for shifting the risk for toxic waste losses to investors

SECThe Securities and Exchange Commission today announced a settlement in which Bank of America admits that it failed to inform investors during the financial crisis about known uncertainties to future income from its exposure to repurchase claims on mortgage loans.

Bank of America also is resolving securities fraud charges that the SEC filed last year related to a residential mortgage-backed securities (RMBS) offering.

In the SEC’s original case against Bank of America filed in August 2013, the agency alleged that the bank in its own words “shifted the risk” for losses to investors when it failed to disclose that more than 70 percent of the mortgages backing the RMBS offering called BOAMS 2008-A originated through its “wholesale” channel of mortgage brokers unaffiliated with Bank of America entities.  Bank of America knew that such wholesale channel loans – described internally as “toxic waste” – presented vastly greater risks of severe delinquencies, early defaults, underwriting defects, and prepayment.

Bank of America has agreed to settle the two cases by paying $245 million as part of a major global settlement announced today by the U.S. Department of Justice in which Bank of America will pay $16.65 billion to resolve various investigations involving violations of laws regulated by other federal agencies.

“Bank of America failed to make accurate and complete disclosure to investors and its illegal conduct kept investors in the dark,” said Rhea Kemble Dignam, regional director of the SEC’s Atlanta office.  “Requiring an admission of wrongdoing as part of Bank of America’s agreement to resolve the SEC charges filed today provides an additional level of accountability for its violation of the federal securities laws.”

In new charges filed by the SEC today in a settled administrative proceeding, Bank of America admits that it failed to disclose known uncertainties regarding potential increased costs related to mortgage loan repurchase claims stemming from more than $2 trillion in residential mortgage sales from 2004 through the first half of 2008 by the bank and certain companies it acquired.  In connection with these sales, Bank of America made contractual representations and warranties about the underlying quality of the mortgage loans and underwriting.  In the event that a loan buyer claimed a breach of a representation or warranty, the bank could be obligated to repurchase the related mortgage loan at its outstanding unpaid principal balance. 

In the SEC’s original case against Bank of America filed in August 2013, the agency alleged that the bank in its own words “shifted the risk” for losses to investors when it failed to disclose that more than 70 percent of the mortgages backing the RMBS offering called BOAMS 2008-A originated through its “wholesale” channel of mortgage brokers unaffiliated with Bank of America entities.  Bank of America knew that such wholesale channel loans – described internally as “toxic waste” – presented vastly greater risks of severe delinquencies, early defaults, underwriting defects, and prepayment.

As part of the global settlement, Bank of America agreed to resolve the SEC’s original case by paying disgorgement of $109.22 million, prejudgment interest of $6.62 million, and a penalty of $109.22 million while consenting to permanent injunctions against violations of Sections 5, 17(a)(2), and 17(a)(3) of the Securities Act of 1933.  The settlement is subject to court approval.  To settle the new case, Bank of America agreed to pay a $20 million penalty while admitting to facts set out in the SEC’s order, which requires Bank of America to cease and desist from causing any violations and any future violations of Section 13(a) of the Securities Exchange Act of 1934 and Rules 12b-20 and 13a-13. 

The August 21, 2014 SEC Proceeding excerpted - 

Between 2004 and the first half of 2008, Bank of America and certain companies that it acquired in the second half of 2008 (the “acquired companies”) sold approximately $2.1 trillion of mortgage loans and residential mortgage backed securities (“RMBS”). Of the $2.1 trillion total, approximately $1.1 trillion were mortgage loans sold to Government-Sponsored Enterprises (“GSEs”), primarily the Federal National Mortgage Association (“Fannie Mae”) and Federal Home Loan Mortgage Corporation (“Freddie Mac”). The remaining $963 billion were sold to whole loan investors and into private label securitizations, frequently bought by large institutions. Roughly $160 billion of mortgage loans were sold into private label securitizations containing a credit enhancement provided by a monoline insurer. Approximately $1.8 trillion of the overall loan amounts remained outstanding as of December 31, 2009.

3. In connection with the sale of these mortgage loans and RMBS securitizations, and credit enhancements provided by monoline insurers, Bank of America, or the acquired companies, made contractual representations and warranties regarding the underlying mortgage loans. While terms varied by agreement and counterparty, examples  of the types of representations and warranties upon which claims could be based included good title, conformity with underwriting guidelines, enforceability of mortgage documents, lien position, and compliance with applicable laws.

4. If a purchaser of these loans or RMBS securitizations determined that there had been a breach of a representation and warranty, the purchaser could assert a claim against Bank of America or the acquired companies and demand that the related mortgage loan be repurchased at its outstanding unpaid principal balance. Bank of America or the acquired companies would review such claims and either agree to repurchase the loan or deny the claim. Pursuant to the review process, Bank of America or the acquired companies might request that the purchaser reconsider that claim. Negotiations could lead the counterparty to rescind the claim. When the parties could not reach an agreement as to the resolution of the claim, the claim was considered to be at an impasse.

5. Following the appointment of a conservator for Fannie Mae in September 2008, Bank of America received information indicating that Fannie Mae may be adopting a more aggressive approach to asserting and contesting repurchase claims. Through the second and third quarters of 2009, Fannie Mae increased its rate and volume of repurchase requests. Fannie Mae submitted a combined $3 billion of claims during the final quarter of 2008 and the first three quarters of 2009. During this same time period, Fannie Mae’s rescission rate (the percentage of claims appealed by Bank of America and subsequently rescinded by Fannie Mae) declined. As a result, the number of “contested” or “impasse” Fannie Mae claims grew from $41 million at Q3 2008 to $512 million at Q3 2009 and continued to rise steadily thereafter. During the second and third quarters of 2009, a
known uncertainty existed as to whether future repurchase obligations to Fannie Mae would have a material effect on Bank of America’s future income from continuing operations.

6. Between 2004 and 2008, Bank of America and the acquired companies sold approximately $160 billion of RMBS with monoline insurance. Bank of America did not reserve for claims not yet submitted by the monoline insurers, or for claims submitted and rejected by Bank of America, but not rescinded by the monoline insurers. These contested claims increased from $203 million at September 30, 2008 to nearly $1.7 billion at September 30, 2009. During the second and third quarters of 2009, there was a known uncertainty as to whether future costs related to loans Bank of America would ultimately be required to repurchase from the monolines would have a material effect on Bank of America’s future income from continuing operations.

7. Bank of America failed to disclose these known uncertainties in its Forms 10-Q for the second and third quarters of 2009 (filed on August 7, and November 6, 2009).  A Bank of America registration statement supplement effective in December 2009 incorporated by reference the periodic filings. In each of these filings, Bank of America’s MD&A failed to comply with the disclosure requirements of Item 303 of Regulation S-K. As a result of its failure to comply with Regulation S-K, Bank of America violated Section 13(a) of the Exchange Act and Rules 12b-20 and 13a-13 thereunder.

C. UNCERTAINTIES REGARDING CLAIMS - Fannie Mae
9. Between 2004 and 2008, Bank of America sold approximately $1.1 trillion of mortgage loans to the GSEs, including Fannie Mae, which purchased $826 billion or 75% of that amount.

10. The GSEs purchased and securitized mortgage loans as part of their goal to provide government supported funding to the housing market. They were the largest purchasers of mortgage loans and they also had the strongest representations and warranties contact rights. The GSEs had a long history with Countrywide of asserting and resolving repurchase claim requests.

11. Bank of America reserved for GSE repurchase expenses using historical loss experience, including past GSE repurchase rates.

12. From at least 2005 through mid-2008, Fannie Mae served as Countrywide’s GSE “alliance partner.” Under this arrangement, which Bank of America later continued, Countrywide sold most of its mortgage inventory to Fannie Mae. Based on that relationship, Fannie routinely rescinded certain types of claims rather than fully assert its contractual rights to have the repurchase claims paid.

13. By the time Bank of America completed its Countrywide acquisition in July 2008, housing market conditions had deteriorated. On September 6, 2008, the Federal Housing Finance Agency placed both Fannie Mae and Freddie Mac into conservatorship. 

14. Through the first three quarters of 2009, Fannie Mae greatly increased the amount of repurchase claims submitted to Bank of America and increased the claim rate  per loan default at which it was submitting claims. The claims continued to increase thereafter. Fannie Mae also became more restrictive in rescinding those requests. 

15. In addition, there was a continuing increase in accumulated “contested” or “impasse” claims—Fannie Mae repurchase claims reviewed and denied by Bank of  America, but which Fannie Mae did not rescind. The cumulative amount of Fannie Mae contested claims grew from $41 million at Q3 2008 to $512 million at Q3 2009 and continued to rise steadily thereafter.

16. Bank of America managers in the Home Loans & Insurance (“HL&I”) division, which was responsible for handling the repurchase claims, were aware of other information which also indicated that Fannie Mae might be adopting a more aggressive repurchase policy. During February 2009, Fannie Mae circulated a draft policy to Bank of America, enunciating a more aggressive approach to repurchase claims. Although that policy did not become effective, Fannie Mae conveyed its intention to alter its position on the resolution of certain types of repurchase claims by promulgating and implementing new policies. In the second and third quarter of 2009, Fannie Mae began to promulgate and implement these new policies, which took a harder line and more contractual rights based approach to certain types of repurchase claims. As a result, Bank of America observed the increase in Fannie Mae contested claims and received reports that detailed the status of representation and warranty repurchase claims.

17. In a letter received by Bank of America on October 20, 2009, Fannie Mae documented its position on “policy misalignments” i.e., disagreements as to the standards which should be applied in resolving claims. The letter stated that Fannie Mae “expects and requires all lenders to honor the terms of their contracts and to abide by the rep and warrant policies.”

Monolines
18. Monoline insurers provided credit enhancement in connection with RMBS in the form of a guarantee to RMBS investors that principal and interest payments would be made in the event there was insufficient cash flow from mortgage payments to meet the RMBS obligations. As part of the insurance agreement, Bank of America or the acquired companies made representations and warranties to the monoline insurance company regarding the mortgage loans that made up each insured securitization. 

19. Monoline insurance companies insured approximately 17% of the mortgage loans sold by Bank of America and its acquired companies to private label investors, mostly large financial institutions. Between 2004 and 2008, Bank of America and the acquired companies sold approximately $160 billion of RMBS with monoline insurance. 

20. Managers in the HL&I division, which was responsible for handling the repurchase claims, received reports that detailed the status of representation and warranty repurchase claims and observed the increase in contested monoline claims. By at least as early as November 24, 2008, Bank of America’s internal auditors identified monoline repurchase claims exposure as an “emerging risk.” Bank of America management was aware of the increasing claims. As one example, in June 2009, an internal Bank of America report contained a “Trends Summary” showing monoline claims outstanding trending up from $326 million in May 2008 to $2.3 billion in May 2009.

G. APPLICABLE LAW
Section 13(a) of the Exchange Act and Rules 12b-20 and 13a-13 require every issuer of a security registered pursuant to Section 12 of the Exchange Act to file with the Commission information, documents, and quarterly reports as the Commission may require, and mandate that periodic reports contain such further material information as may be necessary to make the required statements not misleading. “The reporting provisions of the Exchange Act are clear and unequivocal, and they are satisfied only by the filing of complete, accurate, and timely reports.” SEC v. Savoy Industries, 587 F.2d 1149, 1165 (D.C. Cir. 1978). Rule 12b-20 of the Exchange Act requires an issuer to include in a statement or report filed with the Commission any information necessary to make the required statements in the filing not materially misleading.

Item 303 of Regulation S-K requires MD&A as a part of reports filed pursuant to Section 13(a). Item 303(a) of Regulation S-K requires registrants to disclose in annual filings “any known trends or uncertainties that have had or that the registrant reasonably expects will have a material favorable or unfavorable impact on net sales or revenues or income from continuing operations” and “information that the registrant believes to be necessary to an understanding of its financial conditions [or] changes in [its] financial conditions.” Instruction 3 to Item 303(a) further provides that “[t]he discussion and analysis shall focus specifically on material events and uncertainties known to management that would cause reported financial information not to be necessarily indicative of future operating results or of future financial condition. This would include descriptions and amounts of…matters that would have an impact on future operations and have not had an impact in the past….”

Item 303(b) applies the identical disclosure requirements to interim reports, specifically stating that MD&A relating to interim period financial statements “shall include a discussion of material changes in those items specifically listed in paragraph (a) of this Item, except that the impact of inflation and changing prices on operations for interim periods need not be addressed.” The Commission reiterated and emphasized these interim period disclosure requirements in an Interpretive Release issued in 1989, stating:

“The second sentence of Item 303(b) states that MD&A relating to interim period financial
statements ‘shall include a discussion of material changes in those items specifically listed
in paragraph (a) of this Item, except that the impact of inflation and changing prices on
operations for interim periods need not be addressed.’ As this sentence indicates, material
changes to each and every specific disclosure requirement contained in paragraph (a), with
the noted exception, should be discussed (emphasis added). The purpose of MD&A is “to
give the investor an opportunity to look at the company through the eyes of management by
providing both a short and long-term analysis of the business of the company.”

SEC Interpretation: Management’s Discussion and Analysis of Financial Condition and Results
of Operations; Certain Investment Company Disclosures, Exchange Act Release No. 26831 (May 18, 1989) (“MD&A Release”).

The MD&A Release also sets forth a test concerning these disclosure requirements. If a trend, demand, commitment, event or uncertainty is known, management must make two assessments:

(1) Is the known trend, demand, commitment, event or uncertainty likely to come to fruition? If management determines that it is not reasonably likely to occur, no disclosure is required; and

(2) If management cannot make that determination, it must evaluate objectively the consequences of the known trend, demand, commitment, event or uncertainty, on the assumption that it will come to fruition. Disclosure is then required unless management determines that a material effect on the registrant’s financial condition or results of operations is not reasonably likely to occur.

The Commission also has explained that “reasonably likely” is a lower disclosure threshold than “more likely than not.” Commission Statement About Management’s Discussion and Analysis of Financial Condition and Results of Operations, Release Nos. 33-8056 and 34-45321 (January 25, 2002).

During the relevant period, Bank of America failed to disclose known material uncertainties relating to (1) whether Fannie Mae had changed their repurchase practices after being put into conservatorship, and the increasing number of claims and increasing inventory of contested claims from Fannie Mae; and (2) the future volume of repurchase claims from monoline insurers and the ultimate resolution of mounting contested monoline claims. With regard to these uncertainties, Bank of America neither determined that they were not reasonably likely to come to fruition, nor determined that, if they came to fruition, they would not have a material impact on income from
continuing operations. These uncertainties indicated a material risk to future income from continuing operations. Accordingly, disclosure was required. See Panther Partners, Inc. v. Ikanos Communications, Inc., 681 F.3d 114, 122 (2d Cir. 2012) (concluding that Item 303 required disclosure of known uncertainty regarding potential returns of product and risk to future income).

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