SEC v. Nocella: Executives not Barred for Improper Accountings to the FDIC
In SEC v. Nocella, Civil Action H-12-1051, 2014 BL 222069 (S.D. Tex. Aug. 11, 2014), the United States District Court for the Southern District of Texas declined to grant the request to bar two bank executives from serving as an officer or director at a publically traded company.
According to the Securities and Exchange Commission’s (“SEC”) allegations, Franklin Bank Corporation (“Franklin”) financed single-family and residential mortgages. In 2007, during the brink of the economic downfall, many of the mortgages became past due. Franklin began offering loan modifications to borrowers through three different programs: Fresh Start, Strathmore, and Great News. Each program essentially offered past due borrowers an opportunity to make one payment to make their loan “current.” General accounting principles require a loan to be considered impaired when it is likely that a creditor cannot collect all amounts due. Franklin did not, however, report these loans as modified on its third-quarter public statements. As a result, the FDIC notified Franklin of the improperly classified loans, and Franklin reclassified some of the loans as “non-performing troubled debt restructurings.”
The SEC filed suit against Anthony J. Nocella, the chief-executive officer, and J. Russell McCann, the chief-financial officer. The SEC’s suit sought to bar Nocella and McCann from holding an officer or executive position with any publically traded company. Nocella and McCann filed motions for partial judgment in their favor.
The SEC has the authority to ask a court to bar defendants from serving as an officer or director of a public company under certain circumstances. 15 U.S. Code § 78u(d)(2). For a court to do so, there must be a violation of Section 10(b) of the Exchange Act and substantial evidence to demonstrate “unfitness to serve as an officer or director.” The court has discretion in this analysis and considers the defendant’s actions, as well as the (a) egregiousness of the violation, (b) recidivism, (c) roles in the company during the fraud, (d) degree of scienter, (e) economic stake, and (f) likelihood of future violations.
The court determined Nocella and McCann did not significantly meet any of the factors. With respect to scienter, for example, the court found the “defendants acted with no intent to defraud Franklin's shareholders and with no extreme departure from business judgment. When the FDIC disagreed with the Strathmore loan classifications, Nocella and McCann corrected Franklin's books to reflect its criticisms.”
As a result, while recognizing that the Bank “improperly accounted for modified mortgages under their management,” the court found that it was “abusive to seek a permanent bar against two executives who were working for a troubled company in a troubled time without adequate evidence that they were responsible for the improper accounting.”
The primary materials for this case may be found on the DU Corporate Governance website.