The United States Securities and Exchange Commission (“SEC”) continues to bring enforcement actions focused on government-guaranteed residential mortgage backed securities, notably including those guaranteed by the Government National Mortgage Association (“Ginnie Mae” or “GNMA”). Most recently, on May 31, 2016, the SEC announced that First Mortgage Corp. (“FMC”) and six of its senior executives agreed to pay $12.7 million to settle charges of defrauding investors in the sale of residential mortgage-backed securities (“RMBS”) guaranteed by Ginnie Mae. Importantly, when bringing these cases, the SEC has been seeking penalties against not only the companies but also the senior executives. Another important takeaway is that not only are public companies subject to the enforcement scrutiny of the SEC but, as discussed further below, any issuer of Ginnie Mae mortgage-backed securities is subject to certain aspects of the federal securities laws as well.
The SEC claims that FMC, from March 2011 through March 2015, defrauded investors in Ginnie Mae-backed RMBS by falsely claiming loans were delinquent when, in fact, FMC withheld payments by the mortgagors that should have been applied to the mortgage loans and remitted to holders of the RMBS. FMC then allegedly incorrectly characterized the loans as delinquent. This allowed FMC to rely on Ginnie Mae guidelines to repurchase the “delinquent” loans from Ginnie Mae pools at par but at prices below market value. Following repurchase, FMC applied the withheld payments to the loans in order to eliminate the artificial delinquency. In turn, FMC could re-pool the current loans into new Ginnie Mae RMBS pools, sell the related securities at the higher market value and capture the spread between that higher price and the repurchase price as a secondary marketing gain. The SEC charged FMC and the executives with violating Section 17(a) of the Securities Act of 1933 (“Securities Act”), and Section 10(b) of the Securities Exchange Act of 1934 (“Exchange Act”) and Rule 10b-5 promulgated thereunder.
The Securities Act Section 17(a) and Exchange Act Section 10(b) are the most commonly cited statutory provisions prohibiting fraud in the United States securities markets. The SEC adopted Rule 10b-5 to implement the fraud prohibitions of Section 10(b). Rule 10b-5 makes it unlawful for any person, in connection with the purchase or sale of securities, directly or indirectly to: (1) employ any device, scheme or artifice to defraud; (2) make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in light of the circumstances under which they are made, not misleading; or (3) to engage in any act, practice or course of business which operates or would operate as a fraud or deceit upon any person. Section 17(a) prohibits similar conduct in connection with the offer or sale of securities. It is critically important for issuers of securities in the GNMA market to understand that they are, and will continue to be, subject to the antifraud provisions of Section 17(a), Section 10(b) and Rule 10b-5. As demonstrated by the SEC’s recent action, the penalties for issuers and their officers for violating these provisions can be severe.
The Details: Charges & Settlement
The SEC alleged that FMC and the executives violated the federal securities laws anti-fraud provisions by failing to disclose FMC’s repurchase and re-pooling practice to investors and Ginnie Mae. The SEC concluded that the failure to disclose these practices rendered statements in FMC’s Ginnie Mae RMBS prospectuses false and misleading. In addition, the SEC claimed that the repurchase and re-pooling practice amounted to a fraudulent scheme against investors and Ginnie Mae because FMC and its executives engaged in several deceptive acts that were instrumental in inducing Ginnie Mae to guarantee the RMBS. The SEC alleged that these acts included:
- Preparing HUD forms that inaccurately, as stated loans were delinquent;
- Providing those inaccurate forms to GNMA and FMC’s loan administrator; and
- Falsely certifying to GNMA that FMC’s loan pools and packages would comply with GNMA rules.
FMC and its executives agreed to pay a total of $12.7 million to settle the charges, without admitting or denying the allegations. The six FMC executives agreed to be barred from serving as an officer or director for a public company for five years and agreed to the following monetary payments:
- Clement Ziroli, Sr. (chairman & CEO) — $100,000 penalty
- Clement Ziroli, Jr. (president) — $411,421.98 plus $27,203.92 in interest and a $200,000 penalty
- Pac W. Dong (CFO) — $100,000 penalty
- Ronald T. Vargas (senior VP, headed FMC’s Capital Markets Department) — $60,000 penalty
- Scott Lehrer (senior VP) — $50,000 penalty
- Edward Joseph Sanders (managing director of FMC’s Servicing Department) — $51,576.51 plus $6,811.19 in interest. (The SEC press release notes that Sanders cooperated in the SEC’s investigation.)
The SEC Enforcement Division has been focusing on RMBS since before the financial crisis. In 2010 it strengthened its ability to bring enforcement actions arising from RMBS by creating a specialized investigative unit now known as the Complex Financial Instruments Unit. The Enforcement Division has now spent almost a decade learning about, investigating and bringing RMBS-related cases and is particularly focused on the intersection between securitization and government-backed mortgages. In announcing FMC, Andrew Ceresney, director of the SEC’s Division of Enforcement stated, “FMC and its senior executives abused their privileged access to Ginnie Mae’s securitization program by allowing greed to corrupt their business practices … It is critical that we hold senior management fully accountable for this kind of misconduct, which we were able to accomplish here quickly due to the cooperation of company insiders.”
As seen in the FMC case and earlier enforcement actions against Taylor, Bean & Whitaker Mortgage and Radius Capital, the SEC’s Enforcement Division will continue to scrutinize issuers in the governmental-backed securitization market and those issuers must be prepared to demonstrate their compliance with the US securities laws and regulations. Issuers of GNMA RMBS must be particularly careful to comply not only with HUD and GNMA regulations but with the requirements of the federal securities laws as well.