Transcript Slide 1

Guidance for
Responding to SEC
and FINRA
Investigations of
Subprime and Related
Loan Products
Subprime Lending Crisis
March 19, 2008
New York
Copyright 2008 Paul, Hastings, Janofsky & Walker LLP
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Confidential – not for redistribution
The Many Heads of Subprime Scrutiny
 SEC
 FINRA
 State Agencies
 Department of Justice
 Treasury Department
 Banking Regulators
 Private Litigants
Copyright 2008 Paul, Hastings, Janofsky & Walker LLP
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Federal Investigations
 SEC
Subprime Task Force
 Formed March 2007
 Over 100 lawyers
 Three dozen active investigations (to date all nonpublic)
 Communicate and coordinate with other agencies and regulators (such as
FINRA)
 SEC jurisdiction limited to public companies and market participants
 Share information with federal criminal authorities
 Department
of Justice
 FBI announced it was investigating 14 companies
 Increasing USAO interest
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Potential Triggers For Subprime Investigations

Subprime Working Group - SEC working group tasked with identifying new matters

SEC “wildcatting” – Enforcement practice of targeting entire industry when major
players engaged in practices that the SEC believes are widespread

Agency cooperation - The SEC and Department of Justice often conduct investigations
in parallel, especially in areas involving complicated accounting rules

Restatement or significant write-downs - Announcements can invite regulatory interest

Suspicious trading activity

Investigation of a related entity or commercial partner – Investigations of lenders can
lead to investigations of related banks, brokers, credit rating agencies and other
commercial partners

Whistleblower

SRO compliance exam – Increased pressure from recent GAO report

Analyst or media reports
Copyright 2008 Paul, Hastings, Janofsky & Walker LLP
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The First Days – Positioning Your Client

With the problem identified, the race is on to complete a timely assessment of
the facts and the scope of the problem

Ensure safekeeping of relevant hardcopy and electronic documents –
Document Preservation/Retention Notices

Identify whether any of the company’s commercial partners or outside
professionals are targets

Consider parallel investigation by the Department of Justice, FINRA, state
attorneys general, or other regulators

Assess whether an internal investigation is warranted

Consider disclosure obligations and possible media concerns

Self-report material violations to the SEC staff

Determine whether to cooperate or defend vigorously
Copyright 2008 Paul, Hastings, Janofsky & Walker LLP
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Dos and Don’ts of Responding to SEC Inquiries
 DO
provide “credible” cooperation
The SEC’s 2001 Seaboard Report remains the operative
policy for evaluating credit for cooperating in an SEC
investigation - self-policing, self-reporting, remediation, and
cooperation with law enforcement authorities
 DO
communicate early and often with the SEC
 DO
set reasonable expectations for the SEC staff
 DO
enter into a confidentiality agreement/non-waiver
agreement before providing privileged information or
documents
 DO
maintain a log of cooperative activities
Copyright 2008 Paul, Hastings, Janofsky & Walker LLP
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Dos and Don’ts of Responding to SEC Inquiries
 DON’T
mislead the staff or provide incomplete
disclosures
 DON’T
provide delayed and inadequate responses to
SEC requests
 DON’T
waive privilege without authorization from
the proper holder of the privilege
 DON’T
neglect potential conflicts that often arise
when cooperating
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Subprime Focus

Primary areas of focus:
 Accounting
 Valuation
 Disclosures

Who knew what, and when?

Broad range of possible violations being investigated

Regulatory focusing on all actors and their roles:
 Issuers
 Underwriters
 Credit Rating Agencies
 Insurance Companies
 Hedge Funds
 Broker-Dealers
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Subprime Lenders
 Was
subprime exposure fairly presented in financial
statements and other disclosures
 Adequate allowances for loan losses
 Proper valuation of loan portfolios
 Accurate and timely disclosure
 Any
motivation to “hide” negative news?
 Insider Trading
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Valuation
 Proper valuation
methodology
 Issues are present in selling, trading and retaining mortgage backed securities on
books
 Are products retained on books accurately?
 Write downs timely?
 Consistent
valuation methodology
 Did investment banks apply the same valuation methods on their books as they
did for their clients? Valued on mark or actual bid?
 Did the investment banks use the same prices?
 E-mail and other communications will be reviewed.
Copyright 2008 Paul, Hastings, Janofsky & Walker LLP
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Securitization and Disclosure
 Regulation AB
 Registration, disclosure, and reporting requirements of publicly offered assetbacked securities
 Were
risks adequately disclosed?
 Prospectuses and marketing materials
 Risks associated with early payment default provisions disclosed?
 Write downs and other disclosures timely?
 Conflicts
of Interest
 Roles of the parties involved in the securitization
 Policies and procedures
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Hedge Funds
 Valuation of subprime securities
 Disclosures to investors
 Risk and monitoring of risk
 Underlying loan performance
 Investment decision/disclosure
 Stated vs. actual
 Concentration of risk
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Credit Rating Agencies
 Credit
Rating Agency Reform Act
 Granted the SEC examination authority
 Requires disclosures in public filings (e.g., conflicts of interest)
 Focus
is on procedures to prevent conflicts of interest.
 Were
proper procedures followed in rating mortgagebacked securities?
 Internal Controls
 Was
there any undue influence by issuers or underwriters
to diverge from stated methodologies?
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Broker-Dealers
 Suitability
 Financial
and disclosures
Industry Regulatory Authority (“FINRA”)
Product of the July 2007 merging of NASD and the
regulatory arm of the New York Stock Exchange
FINRA can “discipline securities firms and individuals in the
securities industry who violate its rules, federal securities
laws, and rules enacted by the Municipal Securities
Rulemaking Board.”
FINRA has conducted sweep examinations into subprimerelated securities
 Disclosure to investors
Copyright 2008 Paul, Hastings, Janofsky & Walker LLP
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Insider Trading
 Were
shares sold before subprime exposure was publicly
disclosed?
 Executives of subprime mortgage lenders
 Executives involved in securitization process
 Financial institutions (including broker-dealers and hedge funds)
 Enforce
policies and procedures
Copyright 2008 Paul, Hastings, Janofsky & Walker LLP
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Doral Financial and First Bank (SDNY) –
(Financial Disclosure Violation)
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
In August 2007, the first case brought by the SEC subprime working group charged
former management of First BanCorp, a Puerto Rico-based bank holding company,
with concealing the true nature of more than $4 billion worth of transactions involving
“non-conforming” mortgages from 2000-2005.

The SEC alleged First BanCorp aided and abetted purported violations by another
Puerto Rico-based bank holding company, Doral Financial Corporation, through
mortgage-related transactions that were not true sales under GAAP
 First BanCorp purported purchased the non-conforming mortgages from Doral Financial. In
doing so, First BankCorp booked more than $100 million in net interest income.
 The SEC alleged that the transactions were not “true sales” because management at Doral
Financial agreed to extend the recourse provision beyond 24 months (i.e., for the entire
duration of the mortgages).

Without admitting or denying the charges, First BanCorp consented to an injunction
from violating the antifraud, books and records and internal control provisions and
agreed to pay an $8.5 million penalty

Doral Financial previously agreed, also without admitting or denying the SEC’s
allegations, to an injunction and $25 million penalty
Copyright 2008 Paul, Hastings, Janofsky & Walker LLP
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R&G Financial Corporation (SDNY) –
(Valuation and Disclosure Violations)
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 On
February 13, 2008, the SEC charged a bank holding
company with mortgage banking operations in Puerto Rico with
overstating income by approx. $180 million through improperly
accounting for mortgage-related transactions in 2002-2004

SEC alleged the company improperly accounted for sales of
non-conforming mortgage loans to Puerto Rico institutions by:
 Recognizing gain on sales of mortgages that were not true sales because
of full recourse provisions in written contracts
 Overvaluing interest-only strips retained by the company in its mortgage
loan swap transactions
 Without
admitting or denying the charges, the company
consented to the entry of an injunction from violating the
antifraud, books and records and internal control provisions
Copyright 2008 Paul, Hastings, Janofsky & Walker LLP
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Thompson Consulting, Inc. – (Disclosure
Violation)
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
On March 4, 2008, the SEC charged a hedge fund adviser and three of its principals
with making undisclosed investments in subprime-related securities.

The SEC alleged that Thompson consulting, a hedged fund adviser, deviated from
its stated investment policy by engaging in a riskier options trading strategy.
 The hedge fund adviser described trading strategy:
 Writing options and receiving premiums almost exclusively on contracts
tied to the S&P 500 index
 Conservatively and safely investing through a short straddle and strangle
strategy
 SEC alleged that in an attempt to increase returns, the hedge fund adviser
changed its investment strategy without disclosure to investors and started
purchasing options on the stock of certain subprime mortgage lenders, and
other volatile indexes, without any hedging. In less than one month (from July
2007 to August 2007) the net asset value of the hedge funds fell from $54
million to approximately $200,000.
Copyright 2008 Paul, Hastings, Janofsky & Walker LLP
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Keith W. MiIler

Keith Miller is a partner in the litigation practice of Paul Hastings in
New York. He is a former SEC enforcement attorney whose practice
focuses on securities litigation and securities enforcement matters.
His clients include some of the world’s leading financial institutions,
including investment banks, broker-dealers, hedge funds, investment
advisers and commercial banks, as well as corporations and their
officers and directors. He frequently represents these clients in
connection with internal investigations, civil litigation and
investigations being conducted by the Securities and Exchange
Commission, the Department of Justice, Congressional committees,
the New York Stock Exchange, Financial Industry Regulatory
Authority (formerly the National Association of Securities Dealers,
Inc.), the Commodity Futures Trading Commission, and various other
state and federal agencies.

Recently, Mr. Miller has represented leading financial institutions in
litigations and investigations relating to the subprime mortgage and
credit crisis, and auction rate securities. He also recently has been
involved in several high-profile regulatory investigations and litigations
relating to failed hedge funds, market timing and late trading, naked
short selling, insider trading and private placement (PIPES)
transactions.

Prior to joining Paul Hastings, Mr. Miller was a partner in Kirkpatrick &
Lockhart Nicholson Graham’s Securities Enforcement and White
Collar Crime Practice Groups. Mr. Miller was also a Branch Chief in
the Securities and Exchange Commission’s Northeast Regional
Office’s division of Broker-Dealer Enforcement and Interpretations.
Attorney
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Keith W. Miller
Partner, Litigation Department
Park Avenue Tower
75 East 55th Street
First Floor
New York, NY 10022
T: 1(212) 318-6005
F: 1(212) 230-7604
[email protected]
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