The Securities and Exchange Commission charged two former executives of Franklin Bank Corp. for concealing the deterioration of the bank’s loan portfolio and inflating earnings during the financial crisis.

The SEC alleges that former Franklin Chief Executive Anthony Nocella and Chief Financial Officer Russell McCann used “aggressive” loan modification programs during the third and fourth quarters of 2007 to hide the number of Franklin’s nonperforming loans and artificially boost its net income and earnings.

The Texas Department of Savings and Mortgage Lending closed the Houston-based bank in November 2008. At the time, the Federal Deposit Insurance Corp. entered into a purchase and assumption agreement with El Campo, Texas-based Prosperity Bank to assume all of the deposits.

“Nocella and McCann used the loan modification scheme like a magic wand to change nonperforming loans into performing assets,” said Robert Khuzami, director of the SEC’s Division of Enforcement. “Their disclosure and accounting tricks misled investors into believing that Franklin was outperforming other banks during the height of the financial crisis.”

Nocella’s attorney, Jay Munisteri, told HousingWire that "the SEC has made a seriously wrong decision in alleging this claim, and we believe confidently that Mr. Nocella will be vindicated. Indeed, conspicuously absent from the SEC’s mischaracterization of events are many important facts that the SEC will not be able to ignore during a court proceeding."

“These claims brought by the SEC have no merit," added McCann's attorney, Barrett Reasoner. "The facts they allege are not accurate and we will prove that. That’s something Mr. McCann feels very strongly about. The evidence does not support the claim that they have asserted in their petition - that’s the bottom line."

As Franklin’s delinquent and nonperforming loans rose significantly in the summer of 2007, the two men instituted three loan modification schemes, causing Franklin to classify those loans as performing, according to an SEC complaint.

By the end of September 2007, the SEC says, Nocella and McCann used the loan modification programs to conceal more than $11 million in nonperforming single-family residential loans and $13.5 million in nonperforming residential construction loans.

“Franklin’s analysts and investors monitored the quality of the bank’s loan portfolio as a key indicator of its financial health,” said David Woodcock, director of the SEC’s Fort Worth regional office. “But Nocella and McCann intentionally concealed the fact that the quality of the bank’s loan portfolio was rapidly deteriorating.”

In May 2008, Franklin acknowledged that the accounting for the loan modifications should be revised and that investors should no longer rely upon Franklin’s Form 10-Q for the quarter ended September 30, 2007.

As of September 30, 2008, Franklin Bank had total assets of $5.1 billion and total deposits of $3.7 billion. Prosperity Bank assumed all the deposits, including the brokered deposits, for a premium of 1.7%. In addition to assuming all of the failed bank's deposits, Prosperity Bank purchased about $850 million of assets.

As a result of the loan modifications, Franklin overstated its third-quarter 2007 net income and earnings by 317% and 77%, respectively, and reported that it earned 30 cents a share, of which 23 cents a share was directly attributable to the loan modifications.

The SEC’s complaint seeks financial penalties, officer-and-director bars, and permanent injunctive relief against Nocella and McCann to enjoin them from future violations of the federal securities laws. The complaint also seeks repayment of bonuses received by the two men under Section 304 of the Sarbanes Oxley Act of 2002, which allows for “clawbacks” of bonuses received by executives if the company later must restate its earnings.

jhilley@housingwire.com

@JustinHilley