Wednesday 26 November 2008
by: William Heisel, The Los Angeles Times
Executives from the Irvine-based New Century Financial Corporation sold their stock knowing the company was in trouble. (Photo: Getty Images)
The subprime lending industry was starting to buckle under the weight of bad loans in November 2006, when executives at Irvine-based New Century Financial Corp. held a conference call to release their latest earnings.
Loan volume was down and defaults were up, the earnings report showed, and in recent weeks at least five stock analysts had downgraded the company's shares. Moreover, four executives had sold nearly $20 million in stock in the last four months, six times as much as they had sold over the previous 12 months.
That led one analyst to ask whether there was anything investors should know.
"It's just part of their personal financial diversification plan," Chief Executive Brad Morrice said in response to the question during the Nov. 2 earnings call.
Those executive stock sales, however, have emerged as a central element in the Justice Department's criminal investigation of New Century, according to a person familiar with the inquiry who was not authorized to speak publicly.
No charges have been filed, and attorneys for the company's former top executives say that none of the executives sold stock based on information that had not been disclosed to the public and that the executives retained most of their shares when the company went under.
"Their stock sales were modest - and entirely appropriate - steps to diversify their assets," said John Spiegel, a Los Angeles attorney who represents five former New Century executives. "Any suggestion to the contrary simply flies in the face of the facts."
Justice Department officials declined to comment on their investigation of New Century, which collapsed into bankruptcy in early 2007 after a short-lived reign as the nation's biggest subprime lender.
The Times conducted its own review of the executive stock trades, analyzing Securities and Exchange Commission filings detailing 277 stock purchases and sales between 2003 and 2007 by six top executives.
Among other things, The Times looked at the executives' use of trading plans to sell stock, mostly after exercising options to buy at a low price and then sell at a much higher price. Federal regulators sanctioned use of such plans in 2000 as a way for executives to engage in regular sales of stock without being accused of making trades based on inside information.
To be an effective shield, however, the plans must be designed and executed carefully, securities experts say.
Although the trading plans themselves do not have to be disclosed publicly, executives routinely disclose when a sale is made under a plan. By reviewing these disclosures, as well as the plans for two of the executives, The Times found that:
Company founders Robert Cole and Edward Gotschall adopted trading plans in June 2006 and then started new ones less than a year later, amid rising loan defaults. Between June and September 2006 alone, the rate of loans that were delinquent more than 60 days climbed nearly 30%. Cole adopted a trading plan on Sept. 15, 2006, and immediately sold 25,000 shares under it the same day. Two other executives, Chief Financial Officer Patti Dodge and Executive Vice President Kevin Cloyd, sold stock within a week of setting up their plans in February 2005. Legal experts say making trades so quickly after a plan is adopted weakens the protection offered by a trading plan, because prosecutors or shareholder attorneys could argue that the plans were drafted to facilitate a quick dumping of shares. All six executives either enacted plans or made trades on the same dates as other executives, which legal experts say could raise questions about whether they were acting in concert on inside information. The trades do not appear to follow regular patterns. Over two years, for example, Morrice made only two sales under his trading plan - and both were in July 2005, allowing him to sell $6.4 million worth of stock before the price fell about 40% later that summer.
Typically, trading plans call for executives to sell a set amount of shares each month or quarter, experts say, and executives usually stick to the same plan for at least a year.
"Any time there is a change in the trading plan, that raises a red flag," said Andrew Stoltmann, a Chicago securities attorney who advises firms on stock trading. "If you put on top of that a share price that's declining and a company that is soon to go into bankruptcy, prosecutors can have a field day with those sorts of facts."
New Century was founded in 1995 by Cole, Gotschall and Morrice, who had worked together at Plaza Home Mortgage in Santa Ana. Selling high-cost loans to high-risk borrowers, they built a subprime lending empire with more than 240 offices in 35 states and more than 7,000 employees, commanded from a high-rise in Irvine.
Fueled by the housing boom, the company's share price closed at an all-time high of $65.14 on Dec. 15, 2004. But it was downhill from there, as New Century and other subprime lenders suffered rising defaults and reduced demand.
In March 2007, New Century disclosed in an SEC filing that federal investigators were "conducting a criminal inquiry under the federal securities laws in connection with trading in the Company's securities, as well as accounting errors regarding the Company's allowance for repurchase losses." Then, on April 2, it filed for bankruptcy protection.
Government investigators have not spoken publicly about the probe since, but former prosecutors and others say the Justice Department is under renewed pressure to bring cases in the wake of the controversial $700-billion rescue plan for the financial industry. Public outrage over the bailout could lead to "a tidal wave of cases that we are going to see across the entire spectrum of the financial industry," said Dan Small, a former federal prosecutor who now works for law firm Holland & Knight in Boston.
Attorneys for the six former New Century executives say their clients believed through late 2006 that the company would make its earnings targets. The executives' faith in the company, they added, was bolstered by interest from Merrill Lynch & Co. and other firms in buying New Century at a significant premium over its share price.
But the examiner hired to review the company's finances by the U.S. Bankruptcy Court said New Century's troubles had surfaced by 2004.
"New Century knew from multiple data sources that its loan quality was problematic, starting no later than 2004," examiner Michael J. Missal wrote in his report this year, adding that "senior management before 2006 took few steps to address the troubling loan quality trends."
For example, the proportionof borrowers who had failed to make payments in the first three months of a loan reached 10% by November 2004 - up from 4.2% in March, according to an internal report filed in a federal lawsuit against New Century by the New York State Teachers' Retirement System.
In 2004, Executive Vice President Stergios Theologides was the only senior executive with a trading plan. By early 2005, after the stock price had peaked, all six of the executives had adopted trading plans.
Unlike Theologides, who had methodically made sales of roughly the same amount over the previous two years, the other executives made trades infrequently, with wide variations in the amounts of shares sold.
"Under these trading plans, you would expect to see a pattern of sales," said David Nolte, a forensic accountant with Fulcrum Inquiry in Los Angeles, which performs investigative audits for government agencies and law firms. "That's not the situation with New Century. That's why, if prosecutors wanted, they could draw a distinction between a plan that is legitimate and a plan that is a ruse."
Dodge, the chief financial officer, set up her plan on Thursday, Feb. 17, 2005, and sold one-fifth of her holdings the following Tuesday. She exercised stock options that allowed her to buy shares between about $5 and $9 for a total of about $56,000 and sell them at $50 for nearly $350,000.
Gotschall, the board vice chairman, also set up a plan Feb. 17. He made his first sale under that plan June 8: 100,000 shares for $5.2 million. He did not use that plan for any other sales. Instead, he started a new plan in May 2005 and sold shares on two days in September for about $3.2 million.
Gotschall adopted a new plan in June 2006 and another in November 2006. Although retired from his job as chief financial officer, he continued to serve on the board of directors. Cole adopted seven plans in 2005-06. He retired as CEO in June 2006 but remained chairman of the board.
Manny Abascal, Cole's attorney, said he changed plans so often because he was setting different floor prices for the stock to ensure that he did not get rid of his shares too cheaply. In some cases, that actually prevented him from selling stock. For example, he was unable to sell 50,000 shares in November and December 2006 because the share price never hit $40.
"These plans are flexible and can be changed when circumstances change, and there's nothing wrong with that," said Abascal, who is with law firm Latham & Watkins in Los Angeles.
But Small, the former prosecutor, said changing plans defeats the purpose of having one.
"The whole point of those plans is to have them in place and being executed on a regular, routine basis," Small said.
By early 2006, the company was seeing a huge increase in the amount of claims from investors who had bought New Century loans and now wanted their money back.
Typically, investors make these demands when borrowers miss payments. Such claims more than doubled in less than six months, from $75.3 million in January 2006 to $151.2 million in May 2006, according to internal company documents filed with the teachers' lawsuit.
Spiegel and Abascal have moved to dismiss that suit, saying the trading plans eliminated the potential for insider trading. A ruling on that motion is pending.
The two attorneys say their clients were bullish on the company, noting that Cloyd, Dodge and Morrice continued to buy shares into late 2006. Morrice and Cloyd bought more shares than they sold in 2006. The attorneys cited a March 2006 offer from Merrill Lynch to buy New Century at about $55 a share, when the stock was trading in the mid-$40 range. The offer was rejected.
In June 2006, Dodge, Cole and Theologides - who hadn't traded for nearly a year - adopted new trading plans that allowed them to kick-start their stock sales. Gotschall also adopted a new plan that allowed him to ramp up sales.
Together, the four executives sold nearly half a million shares from July to October 2006. By comparison, in the 12 months from July 2005 to June 2006, only Gotschall sold any shares, a total of 75,000.
Cole sold $4.7 million worth of shares, or about 7% of his stake in the company, on Aug. 7, 2006, under one of his plans.
He had a second plan at the time but never used it, according to his attorney. Instead, on Sept. 15, Cole adopted four new plans - one to cover stock sales for each of the next four months.
These plans authorized a sale of 25,000 shares immediately and another 25,000 shares three weeks later. Cole reported selling the shares for $2 million.
"If it looks like you are adopting it and trading the same day or shortly thereafter, it looks like you're just making a bet on current information," said David Priebe, an attorney with DLA Piper in East Palo Alto who helps set up trading plans.
Abascal said the decision to sell Sept. 15 was made by Cole's broker, who was operating under a 14-day trading window and picked the first day that the stock price was above $40.
By the time of the Nov. 2, 2006, earnings call, New Century's financial footing had worsened, with the company reporting that the rate of people failing to make their first loan payment had nearly doubled from 2005.
Morrice said New Century would adopt tougher lending standards in hopes of curbing defaults, but added that "the impact to our overall results is not expected to be significant."
Investors kept heading for the exits, driving New Century shares down to $37.23 on Nov. 17, from more than $50 six months earlier.
On Nov. 18, Gotschall adopted a new trading plan, his fourth in less than two years. Two days later, on Nov. 20, he sold about $2.4 million worth of stock under that plan.
One day later, on Nov. 21, Gotschall sold nearly $5 million in stock after exercising about 75% of his remaining options, also under that trading plan.
Spiegel, who is with law firm Munger, Tolles & Olson in Los Angeles, said Gotschall's June 2006 trading plan called for him to sell stock just days before the Nov. 2 earnings release - and a sale just before that disappointing report might draw criticism. As a result, Spiegel said, Gotschall adopted a new trading plan, which allowed him to push the sales back a few weeks.
Securities experts, however, said that whatever the motivation - good or bad - changes to trading plans undermine their purpose.
"The whole idea is you don't have any control over your sales, and if you go in and make changes or make other sales, then you are back in control," said Thom F. Carroll, a financial planner with Carroll, Frank & Plotkin in Baltimore. "You're now changing the rules to meet your needs, and it's not a trading plan under that safe harbor. It's whatever I want to do whenever I want to do it."
Within three months of Gotschall's November sales, New Century shares lost 50% of their value. By March, the company had collapsed and trading in its shares was halted by the New York Stock Exchange.