On January 9, 2013, the Securities and Exchange Commission sued three former officers of Commonwealth Bankshares, Inc., ("Commonwealth") a bank holding company in Norfolk, Virginia, with misrepresenting the bank's true condition by fraudulently reporting the condition of the construction and development loan portfolio of Commonwealth's primary subsidiary, Bank of the Commonwealth ("the Bank"). As the SEC detailed in its press release, the complaint charges three individuals – Commonwealth's former CEO, CFO and Commercial Loan Officer – with manipulating Commonwealth's earnings in the wake of the 2008 economic crisis by understating its allowance for loan and lease losses ("ALLL"), non-performing loans, and other real estate owned ("OREO"). According to the SEC's complaint, these mischaracterizations enabled Commonwealth to present the false impression to the investing public that despite the economic crisis, "all was well" at Commonwealth.
As is typical in such actions, the SEC's complaint is notable for its depth (157 paragraphs of allegations spanning 50 pages) and breadth (eight different theories of liability and nine different prayers for relief, including requests that monetary penalties and industry bars be imposed on the defendants). In addition to its bulk, the complaint is significant as the latest manifestation of a growing trend of enforcement actions premised on alleged false statements of ALLL. While such allegations had become commonplace in class action suits against financial institutions by disappointed investors in the wake of the financial crisis, the government had traditionally shied away from such theories in light of the difficulty inherent in proving that the loan categorization process – which necessarily contains a sizeable amount of subjective judgment – could support a regulatory enforcement action or criminal prosecution.
While behind the curve set by the plaintiffs' bar, the government has recently joined the growing mass of litigants asserting civil and criminal complaints against financial institutions that may have been guilty of nothing more than failing to predict the severity of the worst economic crisis since the great depression. (In June, we detailed the recent investigations of SIGTARP, another government agency, into alleged ALLL manipulation). The SEC's most recent foray into this area further cements the conclusion that the government has determined that ALLL manipulation represents a viable enforcement theory, and that those in the banking industry should expect the uptick in government-sponsored actions employing that theory to continue.
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