Sell-Side Has Issued Favorable Reports, While Being Paid Millions By BOFI To Sell Into The Market

Summary

• Amidst a variety of recent allegations, sell-side analysts have rushed to defend BOFI and recommend that investors purchase the stock.
• BOFI has been the single largest seller of its own stock since 2013. BOFI has sold 1.7 million shares (including several particularly well-timed sales) under an ongoing At-The-Market Offering Program.
• As distribution agents for the program, BOFI's primary sell-side research firms have received over $3 million in total combined payments directly from BOFI over the past three years.
• An enormous conflict of interest, the research firms have profited from selling BOFI's shares in the open market while, in some cases, simultaneously issuing glowing reports touting the company's prospects.
• Anecdotal evidence indicates that BOFI may be using the ATM program as a tool to reward favorable research. As such, the objectivity of BOFI's sell-side research may be compromised.

"There is a belief by most American investors, who may be unsophisticated but remain a critical part of the Nation's capital markets, that analysts are somehow on their side. That an analyst is your advocate. They are impartial. They are bringing you information as your advocate." -The WatchDogs Didn't Bark: Enron And The Wall Street Analysts. United States Senate Hearing. February, 2002.

Bank of the Internet (BOFI) has been the subject of several publicly available research reports that have raised questions regarding the bank's business model, lending practices, and expensive stock market valuation. Most recently, BOFI was the subject of an unflattering New York Times profile, followed by last week's whistle-blower protection lawsuit filed by a former internal auditor.

The company hosted a conference call last Wednesday in an effort to refute the allegations contained in the complaint. During the call, CEO Greg Garrabrants described the suit as containing "factually inaccurate allegations from an inexperienced, underperforming, junior audit team member" and being "riddled with evidence of basic misunderstandings, inaccuracies, out-of-context statements and illogical conclusions." Mr. Garrabrants also pointed to an ongoing conspiracy of some sort coordinated by short sellers:

"But I will guarantee you in my view anyway, by the time we are done, we will find a coordinated effort with the media, with short sellers, and with Mr. Erhart to provide a variety of material non-public information to individuals who ultimately have been worried about the dollar sign. But they are going to have to remove the [S]. So instead they can be worried about tiny bars."

"There's a lot more going on here, and we have absolutely nothing to hide, and I am extremely unhappy with these sort of factual inaccuracies. And so, obviously, I look forward to attributing some component of our share price decline, and ensuring that the John Doe's name will include all the short sellers who are participating in this action, appropriately reward the Bank and the shareholders for any losses they took today."

Predictably, the sell-side analysts appear to have accepted this narrative and have immediately circled the wagons to defend Bank of The Internet. After the call, all four of BOFI's primary research firms upgraded the stock in notes that mostly restate management's talking points. FBR & Co., which appears to have emerged as one of the company's chief promoters, issued a report concluding that "the company did a great job addressing investor concerns". FBR's opinion appears to have been bolstered by confidence from "recent travels with management" that were described in a research note published earlier this month.

Throughout the call, Mr. Garrabrants pointed towards underlying financial incentives:

"If you think about the economic interest there has to be something else going on and we all know what it is. I think those are all important considerations to think about..... We will see ultimately what sort of payments are flowing to participants here."

Mr. Garrabrants is correct in his belief that financial incentives have a strong influence and so should be questioned. Certainly, short sellers benefit financially from declines in share prices and so their research should be scrutinized accordingly. However, this goes both ways. In the case of BOFI, many investors may not understand how significant the financial incentives have become for the sell-side firms that provide "objective" research on the company. In fact, BOFI appears to have become something of a golden goose to the revenue-starved firms that provide research coverage.

A review of SEC filings shows that all four of the primary sell-side research firms currently covering BOFI have received over $3 million in total combined payments directly from BOFI over the past three years. The firms have earned these large fees by selling significant quantities of BOFI shares consistently in the open markets (on BOFI's behalf) as part of BOFI's ongoing At-The-Market Offering program (ATM). The firms have sold millions of dollars worth of BOFI shares to investors while, in some cases, issuing glowing reports to their clients that recommend the purchase of BOFI shares. An enormous (although disclosed) conflict of interest, this puts the sell-side firms on the opposite end of an investment they are touting to their clients. In addition, anecdotal evidence shows that BOFI may be using its ATM offering as a tool to compensate firms that have issued positive research opinions. By creating large financial incentives for favorable research, BOFI may have compromised the objectivity of the sell-side's research on the company.

In the wake of enormous growth and stock price appreciation, BOFI appears to have developed a passionate and almost cult-like following, especially amongst individual investors. It is concerning that many of these BOFI holders appear to be finding encouragement in the recent positive sell-side reports because many individuals may mistakenly believe them to be authored by objective and impartial company watchdogs. It is extremely important for investors to be aware that, especially in the case of BOFI, the sell side has substantial underlying conflicts of interest. BOFI's research analysts face significant pressures because their firms have a large financial interest in keeping BOFI's share price high. All too often, retail investors have been left with large losses after having relied on reports issued by "trusted experts". The purpose of this article is to highlight these conflicts and encourage all investors to exercise their own judgment.

Bank of the Internet's ATM Offering Program

Some Bank of the Internet investors may be surprised to learn the identity of the single largest seller of BOFI shares over the past several years: the company itself.

BOFI adopted an ATM program starting in March 2013. For those unfamiliar with the program, it is exactly the opposite of a stock buyback program. In an ATM offering, the company sells newly issued shares into the secondary market at prevailing prices. Serving as an ongoing capital raise, BOFI has used the ATM proceeds to help fund its fast-growing balance sheet and exotic loan portfolio.

A key factor of an ATM program is that the company needs a sell-side firm to serve as its distribution agent and sell stock into the market. The footnotes to the company's most recently filed 10-K (starting on page F-49) contain a summary of BOFI's ongoing ATM program. The company's disclosure tables are consolidated and reproduced below (totals in thousands):

Critically, BOFI pays its sell-side distribution agents 2.5% of the gross sale proceeds, which makes being BOFI's distribution agent a very lucrative business. In total, Bank Of the Internet has issued over 1.7 million shares (representing roughly 10% of its total shares outstanding) for net proceeds of about $125 million. This has generated over $3.2 million in fees that have been paid directly to the same sell-side firms that are entrusted by their clients with providing objective research coverage on the company. With a direct financial interest in keeping the price of BOFI shares high, it's fair to question if the objectivity of the sell-side research reports has been compromised.

BOFI's ATM Program May Be Used To Reward Positive Research Opinions

It appears that BOFI also may be using its ATM program as a tool to reward firms for positive research coverage on its shares. It's notable that all four of BOFI's historically active distribution agents currently have a favorable research opinion:

	Total ATM Fees	Current Research Opinion
Raymond James	$889	"Strong Buy"
Sandler O'Neill	$360	"Buy"
Keefe, Bruyette & Woods	$1,250	"Buy"
FBR Capital Markets	$707	"Outperform"

Click to enlarge

Interestingly, BOFI has changed its ATM distribution agents fairly frequently and its agreements have included a broader subset of firms (below).

March, 2013 Distribution Agents: Raymond James, JMP Securities, Liquidnet, Sandler O'Neil

July, 2014 Distribution Agents: Keefe, Bruyette & Woods (KBW), Raymond James, Stern Agee

February, 2015 Distribution Agents: FBR Capital Markets, Sterne, Agee & Leach, and Raymond James

JMP Securities, Liquidnet, and Stern Agee, all have been authorized ATM distribution agents at various points, but have never actually received any ATM fees. To the extent these three firms have authored research, their reports have been less favorable than the research authored by the firms that have earned fees from BOFI.

Stern Agee, for example, first initiated coverage on BOFI shares in March of 2014 and was subsequently included as a potential ATM agent shortly afterwards in July 2014. However, Stern Agee held a "neutral" research opinion for a portion of both 2014 and 2015. As it turns out, Stern Agee never received any fees as part of the ATM program. The firm downgraded shares in February 2015 and Stern Agee was subsequently sold to Stifel (SF) earlier this summer.

Contrast that with FBR & Co. FBR first initiated coverage on BOFI in November of 2014 with an "outperform" rating. Shortly afterwards, FBR was included as a distribution agent in BOFI's February 2015 ATM agreement. According to SEC filings, FBR began receiving payments from BOFI immediately afterwards. In the middle of March of 2015, FBR issued a report boosting its price target and reiterating that clients should purchase BOFI shares. Nearly simultaneously, FBR sold a total of around 130,000 shares ($11.8 million in value) on BOFI's behalf making March the third most active month of the ATM program's history. In March alone, FBR earned over $300k in fees by selling shares in the open market, quite possibly to many of the same investors that it was recommending purchase to. Having been paid a total of roughly $770k by BOFI so far this year (this amount may be higher once Q3 disclosures emerge), it comes as no surprise that FBR has emerged as a public and staunch defender of the company.

BOFI's Well-Timed Stock Sales Under Its ATM Program

BOFI's ATM program appears to have had some good timing in regard to its sales of BOFI shares. One month that stands out is September 2014. SEC filings indicate that BOFI sold a total of 236,800 shares during the month for total proceeds of $17.2 million. As by far the single most active month in the ATM program's history (and nearly triple BOFI's monthly average ATM proceeds), these sales were made in advance of the company's October 6th announcement that regulatory approval for the H&R Block (HRB) transaction would be delayed. BOFI shares traded sharply lower in the days immediately following the news:

BOFI data by YCharts

Best practices are said to "prohibit the issuer from placing sales orders with the agent during "closed" trading windows under the issuer's insider trading policy and at other times when the issuer possesses material, non-public information".

To be clear, we do not know the exact dates of BOFI's stock sales in September (and October) or the exact date that the company learned (or began to believe) that the H&R Block deal would be delayed. Given the timing, however, it's fair to question whether the company had knowledge of the deal's regulatory delays at the same time it was selling large quantities of shares to investors.

Conclusion

Many investors may mistakenly believe that the conflicts of interests that plagued analyst research in prior decades have been eradicated. Unfortunately, they have not. These conflicts appear to be particularly acute in the case of BOFI, where sell-side firms have earned millions by selling shares to investors while simultaneously issuing favorable research reports. With such a large financial interest at stake, it is likely that these firms will continue to defend the company no matter how bad the fact pattern may become. It is important for investors to understand these conflicts and exercise their own judgment.

Appendix

Investors who believe the impact of these conflicts is insignificant or are simply interested in a more detailed understanding the issue should read a 2013 study, Inside the "Black Box" of Sell-Side Financial Analysts. The study interviewed over 350 analysts and assembled their confidential, and quite candid answers. The study highlights several pressures that can impair objectivity, all of which are particularly relevant in the case of BOFI. Selected portions are included below.

On The Influence Of Investment Banking Revenues

"Similarly, another analyst indicated that investment banking results in pressure on analysts: "You see equity analysts who are very, very reluctant - even after the Spitzer rules - to upset the investment bankers, because the investment bankers bring in so much more profitability. And no, their compensation is not tied to investment banking; but they certainly realize that the success of their company is tied to the performance of this much higher margin business than the business that they're part of.""

On the Importance of A Positive Relationship with Management

"We also find that the analysts' relationship with management is significantly more important for compensation purposes than issuing profitable stock recommendations..."

"Another analyst candidly told us, "Most of the sell-side is worried more about what management thinks of them than they are about whether they're doing a good job for investors.""...

"One interviewee described an experience where company management canceled an already-scheduled road show with the analyst immediately after he lowered his stock recommendation for the company. Another analyst responded, "If I've got a sell rating on a stock, is that company really going to want to come attend a conference we're hosting? Is that company really going to give me three days to go market with them in New York? No, they're not. So you have to factor that in." Another analyst stated, "When a company cuts you off, not only do you lose the information value of that [access], but you actually lose revenue. The company won't come to your conference; therefore, your conference is going to be less important. Clients pay a boat load for that access.""...

"Finally, another analyst said, "I've heard horror stories from other analysts who get cut off from management, and they just have to deal with it. . . It's a fine line. It's a needle you have to thread sometimes, between being intellectually honest yet not offensive. It's always in the back of your mind, because one of the biggest things the buy-side compensates sell-side research firms for is corporate access: road shows, meetings, access to management teams. So you obviously want to keep an amicable relationship with the companies that you follow.""

On The Role Of Analysts In Uncovering Misrepresentation

"Our findings suggest analysts are not focused on identifying indicators that managers may use to misrepresent financial results...

Analysts are not particularly concerned with uncovering misrepresentation of the financial statements and that they generally take the audited financial statements at face value. Thus, analysts should not be considered a strong line of defense against financial reporting irregularities..."

"In our interviews, we asked analysts directly about their attention to "red flags" of potential misreporting and found that most responded that they give little or no consideration to whether the firms they follow are misreporting earnings..."

"Another analyst said that if a company has audited financial statements, "It's somebody else's job to figure out if the information they're giving us is correct. We have to take that on faith.""...

"In sum, our interviews provided evidence that most analysts are not focused on detecting fraud or misreporting."

On The Pressures From Institutional Clients

A separate paper, Does Analyst Independence Sell Investors Short?, explored this topic and concluded that:

"Analysts' relationships with their institutional customers can create incentives for optimism even after the IPO process is complete. An institutional client is likely to feel betrayed if it purchases securities based on a favorable analyst recommendation and the analyst subsequently lowers his or her recommendation, leaving the client to bear the loss... Accordingly, investors themselves create pressure for analysts to maintain positive recommendations even when those recommendations may not be warranted."

Disclosure: I am/we are short BOFI. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.