BANC: Whistleblower Revelations, Bad Loans, And Undisclosed Related Party Transactions

Summary

In this research report, we focus on the single most important issue at present: Has widespread fraud infected the Banc of California?

• We were contacted by a whistleblower with a deep knowledge of Jason Galanis’ business dealings with the Sugarmans. We learned how Jason Galanis’ ownership in regulated companies alongside both Steven Sugarman and Lead Independent Director Brownstein was concealed from the SEC, FINRA, and investors.
• The whistleblower alleged that BANC has engaged in mortgage fraud by hiding bad loans in “mortgage pools”.
• BANC has acquired over $1.7B in mortgage pools tied to disreputable parties with a history of robo-signing and mortgage fraud. Aggressive assumptions produced accounting profits that represent 60% of cumulative pre-tax income since 2013.
• The credit quality of the mortgage loan pools is deteriorating and displays deed record irregularities. BANC marks these loans at a significant premium from where industry experts would expect them to trade.
• Deed records show BANC sold mortgages that “didn’t meet its investment standards” to an undisclosed off-balance sheet entity controlled by insiders. The mortgages then became securitized alongside other loans in a process that suggest it was designed to hide bad mortgages.
• BANC’s opaque securities portfolio increased by $2 Billion during the same timeframe as the undisclosed transactions with the related parties ramped up. If BANC is buying securities comprised of its bad loans, we believe BANC’s balance sheet is at significant risk.
• BANC’s industry-low tangible common equity ratio and loan reserves leave no room for fraud, material losses, or accounting shenanigans.

Note: A call our attorney placed with the bank to request comment was not returned.

IMPORTANT – Please read this Disclaimer in its entirety before continuing to read our research opinion. Investors are encouraged to conduct their own due diligence into these factors. Additional disclosure: This article represents the opinion of the author as of the date of this article. The information set forth in this article does not constitute a recommendation to buy or sell any security. This article represents the opinion of the author as of the date of this article. This article contains certain “forward-looking statements,” which may be identified by the use of such words as “believe,” “expect,” “anticipate,” “should,” “planned,” “estimated,” “potential,” “outlook,” “forecast,” “plan” and other similar terms. All are subject to various factors, any or all of which could cause actual events to differ materially from projected events. This article is based upon information reasonably available to the author and obtained from sources the author believes to be reliable; however, such information and sources cannot be guaranteed as to their accuracy or completeness. The author makes no representation as to the accuracy or completeness of the information set forth in this article and undertakes no duty to update its contents. The author may also cover his/her short position at any point in time without providing notice. The author encourages all readers to do their own due diligence.

Background:

On October 18, 2016 we published a research report which revealed extensive and indisputable ties between Jason Galanis and Banc of California’s (NYSE:BANC) senior-most offers, board members, and founding shareholder . We warned investors of the similarities between BANC and Gerova Financial (OTC:GVFG), a giant NYSE fraud that left investors with nearly total losses.

Soon after our report, the company hired Gerova’s former PR firm and threatened us in a retraction demand that declared a purportedly independent investigation into these issues had already vindicated the company. After we issued another report revealing that the independent investigation was conducted by Steven Sugarman’s personal defense attorney, BANC delayed its 10-Q filing and announced a new internal investigation.

Earlier this week, the company announced the receipt of subpoenas pursuant to a formal SEC investigative order, disclosed that its auditor, KPMG, raised concerns in a letter to BANC, and that Chairman & CEO Steven Sugarman had resigned. Finally, BANC admitted that a previous 8-K “contained inaccurate statements.”

A Whistleblower Emerges

Several weeks ago, a whistleblower contacted us with detailed information regarding the dealings between Jason Galanis and the Sugarmans as well as allegations of fraudulent activity at BANC. The whistleblower supplied documentation revealing that Jason Galanis held a large equity stake in Steven Sugarman’s COR Securities Holdings (a subsidiary of COR Capital). Thus, all of the bank’s transactions with the COR Companies could potentially have been for the benefit of Galanis alongside Steven Sugarman.

The whistleblower states that the transactions were made pursuant to a longstanding partnership between the Sugarmans and Galanis that were purposefully designed to conceal Galanis’ ownership and involvement in regulated companies from the SEC, FINRA, and the investing public.

We believe that the Board has not come clean regarding Galanis because of the risk that the FDIC might interpret this as a violation of the Federal Deposit Insurance Act (which prohibits felons from having either direct or indirect ownership or control). The act states that a knowing violation could result in a fines of up to $1 million dollars a day (an amount now above $1 Billion which would obviously render the bank insolvent).

But we also think the Board may be concerned about their own potential liabilities in light of the now formal SEC investigative order. The whistleblower described how Galanis pledged shares he secretly held in Prospect Global, a public company co-founded and closely associated with BANC’s Lead “Independent” Director Chad Brownstein, to finance his equity investment in COR. The whistleblower states that the existence of this transaction was concealed from the SEC. (Please see the appendix for a more detailed discussion of this transaction, including the forensic steps we took to independently support its existence.)

The most important question now is: Has widespread fraud infected Banc of California?

The whistleblower informed us that Banc of California has engaged in mortgage fraud by hiding bad loans in “mortgage pools.”

To support the allegations, we performed an extensive analysis of deed records across the country. We discovered a series of undisclosed related party mortgage transfers between Banc of California and entities controlled by a BANC subsidiary. After discussions with industry experts, we have identified what we consider to be a number of red flags within the transactions.

These transactions, in our opinion, are extremely troubling and act to significantly increase the fraud risk profile of the Banc of California.

(Note: The whistleblower is not an insider of Banc of California and owes no duty to the bank. We believe the whistleblower was in a position to have knowledge of the information he provided, which we believe to be accurate. However, we have chosen to omit certain allegations which we cannot yet support.)

The Palisades Group

The Palisades Group (“Palisades”) is a registered investment advisor that manages residential loan portfolios. The firm was ostensibly founded in 2012 by former Carrington Capital executives, but the whistleblower informed us that it was created with a strong interconnectedness with Steven Sugarman’s COR Companies. Palisades hired a longtime COR employee and even operated inside an office leased by COR Securities Holdings, a company that we now know was partially owned by Jason Galanis. Banc of California closed its acquisition of Palisades in September 2013 before its abrupt divestiture in early 2016.

BANC’s “disinterested directors” approved a series of related party transactions with Palisades including reimbursement payments to COR Securities Holdings, which may have benefited Jason Galanis. Jason Sugarman was hired as a key Palisades consultant for his real estate expertise, and subsequently earned over $1.3 million in bonuses. We previously exposed Jason Sugarman’s ties to Westmoore, a real estate ponzi scheme.

Banc Of California’s Poorly Understood Earnings Addiction To Gains from Subprime Loan Pool Acquisitions.

Few investors recognize the degree to which Banc of California’s earnings depend on the acquisition of large pools of single family loans. Between 2012 and 2015, BANC acquired over $1.7 Billion in unpaid principal balance of seasoned mortgages. Roughly 70% percent of these pools consisted of Purchase Credit Impaired (NYSE:PCI) mortgages or those that have evidence of credit deterioration after origination.

There was a significant opportunity for investors in this business following the financial crisis because banks were forced to offload billions in distressed mortgages. Since these mortgages could oftentimes be acquired at attractive prices, these deals proved profitable for many investors.

The beauty of the accounting treatment for PCI loans (from the perspective of public companies) is that it relies heavily on the judgment of management. By making optimistic future cash flow assumptions, management is able to significantly increase the accounting profits from the loan pools. Please see Appendix B for a more detailed accounting discussion, including how an implied 2013 change in BANC’s accounting policies began accelerating the recognition of managements estimated PCI gains.

Since the implied accounting change, Banc of California’s earnings have become increasingly dependent on management’s estimated gains from the PCI loan pools. Despite representing just 12% of the bank’s total loan portfolio, we calculate that the bank has earned over $130 million from PCI loans since 2013. This equates to an astounding 60% of the bank’s cumulative pre-tax income earned over the same period!

Based on our conversations with industry experts, an improving housing market has eradicated the PCI bargains that proved so profitable for investors during the financial crisis. This makes us wonder how Banc of California, magically, has continued to earn large (and increasing) returns from this business.

While this earnings stream is clearly unsustainable, our research shows that Banc of Calfornia’s outsized accounting profits may have been enhanced through undisclosed related party transactions.

Banc Of California Has Purchased Loan Pools Tied To Disreputable Parties

We began to search through deed records across the country in an effort to understand the loan-level economics and ownership histories of the mortgages.

We discovered that BANC has acquired large loan pools tied to, among others, a mortgage investment firm named Arch Bay Capital. Based on our review of the deed records, we believe the Arch Bay mortgages comprised a significant percentage of BANC’s $1 Billion seasoned loan acquisitions in 2013. The loans were acquired just months after Arch Bay was shuttered after its private equity backer stormed its office and seized employee laptops. We note that several current key Palisades Group executives and portfolio managers held similar roles at Arch Bay.

Loans purchased by BANC have been attached to robo-signing scandals. The individual named in the upper left of the above document is a notorious robo-signer. Industry experts explain that this is highly problematic because repairing title impairments can be extremely expensive for a bank to resolve.

Furthermore, many of BANC’s purchased loans were originated by fraudulent lenders. These include NovaStar Mortgage (also above), a fraudulent mortgage originator that resulted in a Harvard Business School Case Study (describing how famed short seller, Marc Cohodes, exposed the fraud).

Industry experts we spoke with indicated that loans pools of similar quality would be expected to trade at anywhere between 25% to 55% of unpaid principal. However, Banc of California currently marks its PCI loans at 92% of unpaid principal. While we realize that the housing market has recovered, we question the accounting assumptions made by Steven Sugarman and his associates. We also note that six financial officers have departed BANC since current management took over.

Bad Loans Have Been Sold To An Off Balance Sheet Entity Managed By Related Parties.

According to BANC’s SEC filings, it has consistently sold loans from its seasoned SFR pools that “did not meet the Company’s investment standards.” In aggregate, BANC has sold loans with $529 million of unpaid principal balance or 30% of its cumulative acquisitions. From these sales it has booked cumulative gain on sale income of $30 million. These gains, in turn, have been used to give credence to the quality of the company’s PCI loan valuations.

We believe investors consider these sales to be arms length transactions, however, We have learned that BANC sold mortgages to undisclosed related parties. Deed records across the country show hundreds of loans being transferred from Banc of California to an entity named Palisades Mortgage Acquisition Company, LLC (“PMAC”).

Beginning one month after BANC acquired Palisades, it began transferring loans to Palisades Mortgage Acquisition Company (“PMAC”). According to SEC Filings, PMAC is the conduit for affiliated Palisades Mortgage Loan Trusts (discussed below). Neither the existence of PMAC or its trusts have ever been disclosed by BANC, yet we have evidence that these entities were controlled by related parties.

Documents from the deed records show that PMAC mortgage transfers have been signed by Palisades co-founder, Jack Macdowell, as Co-President of PMAC. These transfers were made when BANC still owned Palisades, making this executive a related party of Banc of California at the time.

We also believe that PMAC is an off balance sheet entity. BANC’s filings named the Palisades Group, LLC as its (now former) subsidiary. Characterized as an asset-light RIA, The Palisades Group was credited with only $2.9M in assets. The fact that deed records attribute tens of millions of loans to PMAC renders it impossible for PMAC to have been consolidated. We also note that PMAC maintains a separate Darien, Connecticut address and notably, has not filed as a foreign LLC in California (as it presumably otherwise would).

These facts are problematic for Banc of California because it creates the impression that these entities were designed to hide bad mortgages. Thus, BANC’s reported gains from the sale of PCI loans may actually reflect sales of bad loans to an off balance sheet entity controlled by related parties.

The Loans Have Been Securitized Inside Undisclosed Mortgage Trusts.

After gestating inside PMAC for a period of time, the loans are transferred to Palisades Mortgage Loan Trusts (PMLTs). Documents show that the PMLTs are tied to Banc of California’s headquarters building and controlled by related parties. We therefore believe the PMLT’s are private mortgage-backed securities created and issued by PMAC.

Deed records show that the trusts have also purchased large quantities of loans from other institutions, introducing the possibility that bad Banc of California loans are being concealed by being mixed into more diverse loan pools. As the whistleblower analogized, “it is easier to hide $1 Million dollars in bad loans in $100 Million than $10 Million.” Industry experts explained that these kind of nefarious maneuvers would be very difficult for regulators to detect.

Deed Records Reveal Numerous Irregularities

Our review of the deed histories for the mortgages obtained by BANC show a number of irregularities. For example, the table below details the ownership history of a mortgage from Palm Beach County Florida. It shows the mortgage starting in an Arch Bay Capital trust and ending up in Palisades Mortgage Loan Trust, Series 2015-1.

We found hundreds of transactions with the same or slightly varying patterns:

• Multiple transactions occurring months apart are recorded on the same day, often times months after the transactions occurred.
• PMAC holds the loans for an extended period of time, sometimes over a year, before transferring to the trusts. Generally, the securitization process occurs shortly after the issuer acquires the loans.
• The mortgages are flipped between the PMLT’s, generally staying for a few months or less.
• Deed records show mortgages being transferred out of the PMLT’s months before they were legally owned by the trusts.
• A significant percentage of loans required the modification of previous loan transfers, a clear sign the loan was subject to robo-signing mortgage fraud.

The industry experts we spoke with expressed significant concerns about this fact pattern, with one expert stating that “the activity is highly irregular, even for the non-performing loan market.”

The largest outstanding question is: who is financing the PMLTs?

BANC Holdings of Opaque Securities

BANC’s securities portfolio has increased by $2 Billion during the same timeframe as the transactions with Palisades have ramped up. If these securities are related to the loan pools that have been securitized, we believe BANC’s balance sheet is at significant risk.

BANC of California’s portfolio includes over $1.3 Billion worth of level 2 assets (described as “structured products” in call reports) that have been subject to only sparse disclosure and subject to management’s valuation models. This leaves BANC investors holding a portfolio of non-transparent securities that far exceeds the bank’s $650 million in tangible equity.

One thing that really stands out to us is the extreme turnover of the securities portfolio. In the first six months of 2016, BANC sold $3.5B and purchased $3.9B in available-for-sale securities–On an average balance of $1.4B. To us, BANC appears to be trading its securities book more like a hedge fund than a bank.

The securities also have abnormally low yields, at less than 2.75%. It seems nonsensical for the bank to be selling its higher-yielding internally originated loans and using the proceeds to invest in lower-yielding collateralized debt securities.

When asked by an analyst from another firm, Steven Sugarman reportedly declined to provide any explanatory detail regarding the bank’s securities portfolio. A call our attorney placed with the bank to request comment was not returned.

We Have Serious Concerns About The Bank’s Balance Sheet And Equity Capital.

The red flags in BANC’s securities book underpin our broader worries about its balance sheet and capital position. Simply put, this is a bank with a negligible margin of safety to absorb losses from either fraud or bad loans (much less pay $100 million over coming years to name the Sugarman’s Soccer Stadium).

BANC has a set aside substantially lower loan loss provisions than peers and its Tangible Common Equity Ratio (which we believe to be the most relevant for equity market investors) is only 5.8% versus 9.5% for peers. Said another way, to protect common equity holders in a manner in line with its peers, it would have to raise $400 million in fresh equity.

Meanwhile, non-performing PCI loans have started to increase significantly after more than doubling in 2015. The bank’s 10K partially attributed the increase to temporary “confusion of borrowers” resulting from a loan servicing change. But the delinquencies increased by another 40% through June, 2016 and now represent $57 million of the $751 million in total PCI loans. Due to PCI accounting treatment, BANC has set aside only $100k in this portfolio.

Appendix A: Galanis Transaction

The whistleblower alleged that the Sugarmans had a longstanding partnership with Galanis that extended across a variety of regulated business concerns including offshore insurance companies, asset managers, and investment banking concerns.

In 2011, one year after the COR Companies led the initial FirstPactrust recapitalization, Steven Sugarman formed COR Securities Holdings to acquire Legent Clearing (now COR Clearing). The whistleblower explains that a deal was struck with Jason Galanis whereby Weston Capital (an entity controlled by Jason Galanis via Fund.com) would provide equity to be used as regulatory capital to acqure Legent. However, Weston’s principal, Albert Hallac, used the capital on other ventures (Weston & Hallac were subsequently charged by the SEC with fraud).

With the Weston transaction no longer viable, the whistleblower described how Sugarman and Galanis agreed that Galanis would contribute 3 million shares he secretly held in Prospect Global. We note that Prospect Global is a now-imploded OTC potash company co-founded and Vice-Chaired by BANC’s lead independent Director, Chad Brownstein. According to the whistleblower, the transaction was drafted by Steven Sugarman and designed to conceal Galanis’ involvement from the SEC, FINRA, and other COR investors.

Documents show that Galanis transferred the shares through his Thorsdale Trust entity to Sugarman & COR in exchange for a preferred interest (convertible into the equity). The complex transaction involved several of the numerous COR entities including, COR Investments II, LLC.

We were able to support the existence of this transaction through a forensic examination of SEC filings. We learned that Galanis secretly held his Prospect Global shares under the name of “Balkan Hellenic Partnership, LP”. Prospect’s SEC filings disclosed that Balkan Hellenic held 4.1 million shares and tellingly, Balkan’s 13 filing contained no signature. After the Galanis/Sugarman transaction, Balkan’s ownership interest disappeared.

Then magically, subsequent filings disclose that Sugarman’s COR companies owned 4.1 million shares of Prospect Global (and Sugarman’s 13D filing offers no explanation as to the origin of the shares). While only 3 million shares were pledged for the transaction, we speculate that Galanis’ other 1.1 million shares were pledged to the other COR entities under some other arrangement.

This further explains why Steven Sugarman began to publicly pump Prospect Global, declaring in 2013 that:

“We think Prospect Global is the best potash investment opportunity in North America”

By the end of 2014, shares would be nearly worthless.

The whistleblower stated that the transaction, which was specifically designed to be concealed from regulators, was made with the full knowledge of Mr. Brownstein. Our first report already established that Chad Brownstein was one of only four shareholders of Prospect’s 2011 reverse merger entity along with Jason Galanis’ wife and best friend.

Appendix B: PCI Accounting Discussion

Accounting for PCI loans falls under FAS ASC 310-30. Unlike non-credit impaired loans, which recognize income based on contractual cash flows, PCI loans recognize income based on expected cash flows. When PCI loans are acquired they are recorded at fair value (i.e. the purchase price) and no allowance for potential losses is recorded. Write-downs are not recorded unless impairments fall below management’s expected cash flow.

Instead of earnings cash interest as the loan is paid down, interest is earned on the difference between expected cash flows and fair value over the expected maturity of the loan pool (called Discount Yield Accretion).

Because expected cash flows and maturities are determined by management and can be changed quarterly, management is able to use optimistic assumptions to significantly increase the accounting profits from the loan pools. And BANC’s accounting for its PCI loans appears to have loosened over the years.

In 2012, BANC filings stated that the company did not recognize Discount Yield Accretion income until the loan was paid off or “on a case-by-case basis when a material event that significantly improves the quality of the loans.” This language disappeared in 2013 when BANC’s PCI loan purchases ballooned from $114M to $473M.