From Terence Corcoran. Home Capital Group didn’t just fall from the edge of a cliff — it was pushed. National Post, May 2, 2017:
On April 19, OSC staff released a “statement of allegations” against the company and its three top executives. According to the OSC, Home Capital — including the highly respected Gerald Soloway — allegedly failed to adequately disclose certain “material” developments in its mortgage lending operations. They had also issued “materially misleading” information and “falsely certified” an annual report.
In the wake of the OSC allegations, Soloway and the other executives have resigned…
That confidence began to evaporate immediately after the OSC’s allegations were filed. Depositors started to flee, leaving Home in a battle to keep the company in cash…
The allegations against Home date back to 2014 and early 2015 and have long since been resolved to the apparent satisfaction of shareholders and investors.
The central issue, now three years old, involved a small number of the 4,000 brokers who provided Home Capital with individual mortgage clients. In 2014, the company discovered that some of those brokers — about 45 were involved — had been providing “fraudulent employment income documentation” on some of the home buyers.
An internal investigation, overseen by James Baillie, a former OSC chair and Home board member, had been completed. As a result, Home terminated 4 underwriters, two brokerages and 30 brokers for exaggerating the income levels of borrowers.
Home acted promptly to change its internal verification systems to ensure the future accuracy of information supplied by brokers.
The OSC claims that the termination of the brokers should have been reported in public statements on the grounds that it was “material information” that could have an impact on new mortgage business and shareholder value…
Home Capital, presumably advised by the top accounting and legal firms in the country, did not disclose the broker issue until July, 2015. The OSC alleges, among other things, that the 2015 disclosures “were not sufficient for a reader to understand the actual nature of the material change, nor the significance of their impact on immediate and future quarters.”…
In late 2016, two years after the broker events, Home reported that after a review of “all of the customer files and the income documentation” there “have been no unusual credit issues on these mortgages.” And since the mortgages covered by the broker issue were CMHC insured, the profit margins on the mortgages were low to start with, amounting to a fraction of Home’s income being put at risk.
So the alleged material mortgage change turned out to be not particularly material. Earlier this year, Home reported 2016 net income of $247-million on gross assets of $29-billion. It expected more growth.
Then along came the OSC to inject an unforeseen material change into the company’s affairs. For what are now clearly insignificant developments in the company’s affairs three years ago, the OSC has thrown the whole company and 30 years of success over a cliff…
At issue is the need for a regulator to appreciate the potential contagion effects of its actions. The “react, don’t think” market behaviours. It is one matter for a regulator to delay regulatory intervention when facts do not support such delay. It is another to intervene after the fact, when the regulated is in compliance and where the legality of its disclosures involve reliance on the opinions of its professional advisors.
And where, in February of 2017, Gerald Soloway announced his retirement from the company, effective May 11. Apparently not good enough, relative to the April 19 announcement from the Ontario Securities Commission. The announcement is actually a Notice of Hearing, scheduled for May 4, and the associated Statement of Allegations. The fact that certain risks are later contained doesn’t take away from whether such risks, and the causes of same, should have been disclosed at the time one first became aware of such risks. There was a period of business slowdown, resulting from concerns about the integrity of income information relating to some of the of the mortgage transactions and the consequent termination of brokers, brokerages and underwriters associated with these issues. If one had doubts about the nature and extent of reasonable disclosure, perhaps would have been far better to have consulted with the Ontario Securities Commission earlier. Instead, from the Statement of Allegations:
IN THE MATTER OF THE SECURITIES ACT
R.S.O. 1990, c. S.5, AS AMENDED
– and –
IN THE MATTER OF
HOME CAPITAL GROUP INC., GERALD SOLOWAY,
ROBERT MORTON and MARTIN REID
STATEMENT OF ALLEGATIONS
OF STAFF OF THE ONTARIO SECURITIES COMMISSION
Staff of the Ontario Securities Commission (“Staff”) make the following allegations:
1. Home Capital Group Inc. (“HCG”) is in the business of offering residential and commercial lending to clients who do not meet the criteria of a bank or larger financial institution. HCG’s residential mortgage portfolio constitutes approximately 90% of HCG’s business. As a lending business whose primary product is residential mortgages, HCG’s growth and performance are measured in part by the number of new mortgages originated (“Originations”) in any given quarter.
2. On July 10, 2015, HCG announced that an ongoing review of its business partners had led it to terminate certain brokers, causing an immediate drop in Originations. The next trading day, HCG’s stock price fell 18.9%, resulting in an approximate $600 million loss in market capitalization and significant investor harm.
3. Prior to this announcement, from February 2015 until July 2015, HCG misled its shareholders as to the immediate and on-going causes of the decline in Originations. Internally, HCG knew it had terminated certain brokers because it had discovered fraud in HCG’s broker channels. In fact, in February 2015, HCG was completing a six-month investigation into fraudulent employment income documentation (“Project Trillium”) which was overseen by a special committee of the Board of Directors (“the Board”). Project Trillium confirmed that HCG was receiving fraudulent employment income documentation through its broker channels which had not been detected by HCG’s underwriting controls. In particular, the findings of Project Trillium highlighted the scale of the fraudulent documentation flowing through HCG, and the serious systemic underwriting control deficiencies within HCG. Given the findings of Project Trillium, HCG implemented two significant changes: (1) termination of certain broker relationships; and (2) specific remediation of its underwriting processes and controls.
4. The changes implemented by HCG had a significant detrimental effect on Originations. First, the termination of brokers, which occurred mainly from November 2014 through the beginning of January 2015, caused an immediate drop in Originations because those specific brokers had historically referred significant volumes of business to HCG. Second, HCG’s changes to its underwriting processes and controls also negatively impacted Originations as they caused HCG’s processing time for mortgage applications to increase significantly, resulting in brokers sending applications to other lenders. Finally, as a result of the planned remediation of controls across all lines of the residential mortgage lending business, HCG itself planned a scale-back of business growth.
5. By February 10, 2015, the following principal investigative findings, remediation planning and action from Project Trillium were known by HCG:
• The insured (“Accelerator”) mortgage business was down by 32.5% compared to Q3 2014;
• Effective January 15, 2015, Accelerator volume targets were being reduced by 50% to $100 million per month;
• HCG had terminated 4 underwriters, 2 brokerages and 30 brokers. There were a number of other brokers on management’s watch list;
• The terminated brokers had a cumulative total of $881.4 million in Originations in 2014, representing approximately 10% of HCG’s total 2014 Originations;
• Significant changes to the internal control structure were required to increase the accountability of the front line of the business, including separating sales from underwriting and implementing an employment income verification team;
• While testing was complete on the Accelerator side of the business, there was a concern that if brokers had supplied fraudulent employment and income documentation on the insured side of the business, they might be doing the same thing for uninsured (“Classic”) mortgages. Work continued on the exposure assessment related to the Classic mortgage portfolio. The Corporate Compliance group was re-verifying employment and income information with employers for a sample of mortgages to salaried borrowers;
• Brokers were moving their business to other lenders because of increased processing times at HCG; and
• Executive compensation was deferred in conjunction with Project Trillium findings, including the compensation of Gerald Soloway (“Soloway”), Chief Executive Officer (“CEO”) and Martin Reid (“Reid”), President.
6. HCG filed its 2014 annual financial statements and Management Discussion & Analysis (“MD&A”) (collectively the “2014 Annual Filing”) on February 11, 2015 and its Q1 2015 interim MD&A (“Q1 2015 Interim Filing”) on May 6, 2015. In its 2014 Annual Filing and Q1 2015 Interim Filing, HCG made materially misleading statements, blaming the decline in Originations on external vagaries such as macroeconomics, seasonality and competitive markets. Within HCG, it was known that the decline could not be attributed solely to the external factors HCG outlined in its public disclosures. Accordingly, each of the 2014 Annual Filing and Q1 2015 Interim Filing were made in breach of subsection 122(1)(b) of the Securities Act, R.S.O. 1990, c.S.5, as amended (the “Act”).
7. Further, statements made on HCG’s May 7, 2015 earnings call breached subsection 126.2 (1) of the Act because they were materially misleading concerning the causes of the drop in Originations.
8. Subsequent to HCG having failed to comply with its continuous disclosure obligations, in June 2015, the Chair of the Audit Committee of the Board (“Audit Committee”) received a Whistleblower memorandum from a Vice President at HCG dated June 1, 2015 entitled, “Failure to Comply with Timely and Continuous Disclosure Obligations and Related Concerns — Fraudulent Mortgages”. The Whistleblower’s memorandum was submitted under the Whistleblower Policy and the Code of Conduct & Ethics Policy of HCG.
9. Finally, on July 10, 2015, for the first time, HCG began to tell its shareholders the reasons for the drop in Originations, by way of the news release issued on July 10, 2015 (the “July 10th NR”) and material change report filed on July 17, 2015 (“the July 17th MCR”). Notably, the facts disclosed in the July 10th NR were known to HCG by February 10, 2015. HCG was also aware that significant changes to the internal control structure would be required by February 10, 2015. All of the foregoing constituted a material change in the business and operations of HCG. Accordingly, HCG was required to issue a new release and material change report within 10 days of the material change, in compliance with section 75(1) and (2) of the Act. This did not occur. In addition, the disclosure made in the July 10th NR and July 17th MCR was not sufficient to enable a reader to appreciate the significance and impact of the material change and therefore did not comply with Form 51-102F3 — Material Change Report (“51-102F3”) of National Instrument 51-102 — Continuous Disclosure Obligations (“NI 51-102”)…
So if everything is now rectified, at least internally, why would the market panic? Issue of more general confidence in disclosures, in terms of what is now disclosed, and…
Contagion effects having less to do with regulatory action than with market perceptions of management integrity?
All wrapped up in reputation…