The SEC charged Franklin Bank Corp.’s former chief executives for their involvement in a fraudulent scheme designed to conceal the deterioration of the bank’s loan portfolio and inflate its reported earnings during the financial crisis. The complaint seeks financial penalties, officer and director bars, and permanent injunctive relief against the individuals from future violations of the federal securities laws. The complaint also seeks repayment of bonuses under Section 304 of the Sarbanes Oxley Act, which allows for “clawbacks” of bonuses received by executives if the company later must restate its earnings.
As alleged, former Franklin CEO Anthony J. Nocella and CFO J. Russell McCann used aggressive loan modification programs during the third and fourth quarters of 2007 to hide the true amount of Franklin’s non-performing loans and artificially boost its net income and earnings. The Houston-based bank holding company declared bankruptcy in 2008. “Nocella and McCann used the loan modification scheme like a magic wand to change non-performing loans into performing assets,” said Robert Khuzami, director of the SEC’s Division of Enforcement. “Their disclosure and accounting tricks misled investors into believing that Franklin was outperforming other banks during the height of the financial crisis.”
According to the SEC’s complaint filed in U.S. District Court for the Southern District of Texas, as Franklin’s holdings of delinquent and non-performing loans rose significantly in the summer of 2007, Nocella and McCann instituted three loan modification schemes that caused Franklin to classify such loans as performing. By the end of September 2007, Nocella and McCann had used the loan modification programs to conceal more than $11 million in non-performing single family residential loans and $13.5 million in non-performing residential construction loans.
As a result of the loan modifications, Franklin overstated its third-quarter 2007 net income and earnings by 317% and 77% respectively, and reported that it earned $0.30 per share, of which $0.23 per share was directly attributable to the loan modifications. On May 2, 2008, in a Form 8-K report filed with the SEC, Franklin acknowledged that the accounting for the loan modifications should be revised and that investors should no longer rely upon Franklin’s Form 10-Q for the quarter ended September 30, 2007.