Home Capital’s still got big problems

Last month, the Financial Post published articles written by, and broadcast an interview of, Terence Corcoran in which Mr. Corcoran questioned the decision by the Ontario Securities Commission (“OSC”) to accuse Home Capital Group (“HCG”) and some of its current and former executives with misleading shareholders. He complained that the OSC relied on public statements I made about HCG, which he claimed were “totally sensational … and erroneous,” and “outrageous,” and none of my statements “has been supported.” He further claimed I “totally exaggerated whatever the situation is” regarding HCG.

Mr. Corcoran told the Financial Post that he did not know me. That’s true, he doesn’t. For the past 30 years, I have provided valuable and timely information to Canadian and United States securities regulators and criminal prosecutors about notorious companies engaged in fraudulent accounting and business practices, such as Lernout & Hauspie, Media Vision Technology, NovaStar Financial, AremiSoft, California Micro Devices, Network Associates, TakeTwo Interactive, Krispy Kreme Donuts, Boston Chicken, and others. Some executives were criminally prosecuted ( e. g., Media Vision Technology executives and the founders of Lernout & Hauspie). Between 2003 and 2005, I was the first to disclose accounting manipulations at aaiPharma Inc., which led to SEC and U. S. Department of Justice actions. The Harvard Business School published a case study about my efforts in NovaStar Financial: A Short Seller’s Battle.

Mr. Corcoran also doesn’t know much about HCG or its statements to investors. Instead, by trying to shift the focus to those — including the OSC — who have called out HCG’s management for its misconduct, Mr. Corcoran does a disservice to investors and to the Canadian taxpayers and their government, which has insured many of the mortgages originated by HCG that were obtained on false statements in the loan applications.

In 2014, the management of HCG determined that about 45 mortgage brokers working for HCG had knowingly and intentionally submitted thousands of false mortgage applications to HCG that materially misrepresented the borrower’s income levels. The entity holding those mortgages ( HCG) depends on borrowers’ monthly payments to sustain its business, though ultimately the people who foot the bill for governmentinsured mortgages are the taxpayers. If borrowers default, then HCG turns to the government for payment, even though HCG’s own brokers caused the problem.

For anyone who watched the meltdown in the U. S. mortgage and banking industry, the HCG brokers’ scheme should have set off alarm bells and immediate public disclosures. But that did not happen. Instead, HCG’s management opened

an “internal investigation” code- named Trillium, notified the OSFI and CMHC in a private letter, and fired two employees and 45 external brokers.

HCG failed to tell the public about what it had found. Instead, it explained why there was a drop in the new mortgages it issued ( called “originations”), by claiming that things like “macroeconomics, seasonality and competitive markets” caused the reduction. Then, in July 2015, HCG issued a news release that failed to explain the significant changes HCG had been required to adopt.

Here are t he subjects Mr. Corcoran should have tackled: Why did the brokers’ fraud happen?

HCG’s sales and underwriting reported through the same channel in the organizational structure, which meant there were no true checks on the management of credit risk. Evidence of this can be seen in the “phantom ticking” behaviour at HCG — that is, HCG’s systems allowed people to check off that a borrower’s income had been verified when it had not. The OSC staff looked at HCG’s internal controls and found that phantom ticking was a “learned” or “systemic practice” of HCG’s underwriting group. In short, HCG allowed brokers to run wild, helping complete the same kind of false applications that drove the mortgage industry in the United States into the ground 10 years ago. It is a fair inference, from the evidence, that ( at best) HCG’s management chose

not to see what the company was doing.

Did HCG e xploit t he fraudulent mortgages to the detriment of investors?

Long- tenured and very senior HCG executives and directors, who knew the company the best, sold millions of dollars of stock in HCG to unsuspecting buyers while the Trillium investigation was ongoing and, according to the OSC staff never told those buyers the truth. People who bought HCG’s stock before 2015 had no idea that HCG was sitting on perhaps $ 1.9 billion of potentially worthless assets. Anyone with even the most superficial understanding of the securities laws disclosure requirements knows that investors cannot make intelligent decisions when the company fails to disclose to them that the company’s assets are materially misstated. And, in the end, the price at which HCG insiders sold stock in 2014, before disclosing Trillium, was about double the share price after management disclosed the mortgage fraud in July 2015. Ask any of those people who bought HCG stock in 2014– 2016 whether they would’ve like to know about Trillium and the answer will be clear.

HCG also did not timely disclose that, for a number of years, it sold some of the loans it made to a company partially owned by its lead outside counsel (who later joined HCG’s board of directors). If HCG was selling its assets to a friendly insider ( such as its own lawyer), then investors would want to know that — because relatedparty transactions must be disclosed under the securities laws. Why? Because related-party transactions may reflect financial manipulations to make assets look more valuable than they really are. That’s what the management of Enron did, and people went to prison for it.

Is there still a problem at HCG?

Mr. Corcoran complained that information about Trillium was old news and he was puzzled that the OSC would take action this year, when the events in question were several years old. But the OSC — like any other l aw- enforcement agency — i nvestigates before it prosecutes. That’s what we should expect from regulators. In any event, there is still a big problem at HCG.

First, by extending loans to unqualified buyers, HCG has exacerbated the housing bubble in Canada and, particularly, in Toronto. HCG has enabled excessive demand in the market by lending money to unqualified buyers to purchase homes, resulting in pushing otherwise qualified buyers out of the housing market and increasing home prices. That problem is very much still alive today.

Second, the HCG board is flawed, even after some members were replaced. There are six board members who were on the board during the Trillium era. According to the OSC staff, they ( a) presided over the flawed underwriting review process, ( b) failed to detect the $ 2 billion in fraudulent mortgage applications for at least two years, ( c) failed to disclose to the public the problems for over a year, ( d) oversaw managers who provided false information about why loan originations were weak in late 2014 and early 2015, ( e) sold stock to the public knowing that Trillium had never been disclosed, ( f ) retained CFO Robert Morton, who the OSC staff accused of boasting about hiding Trillium deep within the disclosures to investors, (g) failed to correct Chairman Kevin Smith’s statement, on April 21, 2017, that “the business is robust” when, in fact, several banks had already limited their clients’ ability to invest in HCG (and Scotiabank had already suspended all sales of HCG GICs to their clients), and ( h) entered into a financing agreement with Healthcare of Ontario Pension Plan without disclosing key provisions of the deal to investors — and investors only learned that the loan was “effectively a DIP (debtor in possession) loan” when HOOPP CEO Jim Keohane described it in a BNN interview.

Finally, we still don’t have a truly accurate picture of HCG’s and the Canadian mortgage industry’s financial health. How many mortgages held by HCG or other companies that bought the loans have defaulted? How many defaulted mortgages were insured by the Canadian government and how much money will taxpayers have to spend to bail out HCG? These are critical questions for the public to consider, especially since the Financial Post published an article on May 26, 2017 i n which fund managers begged Canada’s Finance Minister to save HCG. Why the attacks on me?

I am not a fund manager ( hedge or otherwise); I invest only for myself and my son. I am a vocal critic of companies who misrepresent their true businesses. In over 30 years of investing, during which time I have worked with federal prosecutors and SEC lawyers many times in the United States and in Canada, I have learned that companies that attack critics personally instead of turning a light on their operations are most often the companies with a lot to hide. I have a strong track record of identifying companies with poor and misleading disclosures. Unfortunately, HCG is an example of such a company.