Buyer Beware: BOFI Related Party Loans

Summary

• Rather than publicly addressing transcript alterations, BOFI privately discussed them with at least one analyst (D.A. Davidson), which is potentially a Reg FD violation.
• BOFI's behavior has dire ramifications for ATM underwriters KBW, Raymond James, and FBR.
• I have looked into the company's related party loans and think that the way it has described these loans to the SEC requires further review.
• The company's related party loans may suggest a culture of lax compliance at the Board level, which would explain why the Board never engaged an outside auditor.
• The transcript alteration spectacle is causing a rapid erosion in BOFI's reputation/credibility.

The BofI Holding, Inc (BOFI) situation has taken so many twists and turns in the past few days that I figured I would do my best to give people a quick update on what is happening, before turning to today's discussion. For the "TL/DR" camp, here is a simple summary - based on the behavior of management over the past few days and the lack of an external investigation into Charles Erhart's claims, I think the bank's reputation is irreparably damaged, and I now think BOFI equity is going to be worthless in short order.

Today, I will mostly talk about the related party loans, but I am actively researching a new angle on BOFI. I have also recently uncovered a "quirky" undisclosed BOFI lending relationship... so stay tuned for a potential Part III in this series.

Part I - If you are already caught up on the BOFI situation, skip straight to Part II below, which discusses the Related Party Loans

Here is a quick rundown of what has been going on with BOFI:

1. A former employee sued the company claiming that BOFI retaliated against him for his whistleblower activities... his lawsuit included allegations that the company was less than truthful with federal regulators.
2. BOFI held a conference call to defend against the lawsuit's allegations... on the conference call, it denied accusations that it had defied/mislead regulators.
3. BOFI then produced a transcript of the call and furnished it to the SEC... however, the company decided to substantially modify its version of the transcript.
4. It then had sidebar conversations with at least one sell-side analyst to discuss these modifications (I think this is a Reg FD violation, but I am not a securities law expert).
5. In other words, hours after fervently denying allegations claiming that it had mislead regulators, BOFI turned around and furnished an altered version of its call transcript in what, in my view, is an effort to mislead regulators (by the way, if I was counsel for the plaintiff in the whistleblower retaliation case and knew of this fact pattern, I'd consider it a very early Christmas gift…).

Here is the note from the D.A. Davidson that confirms BOFI had private conversations regarding the transcript modification:

(Source: D.A. Davidson BOFI update note from 10/30/15)

Shockingly, all sell-side firms have made a decision to put 100% faith into management's claims. This defense comes even after most of the research firms have publicly acknowledged that BOFI altered its transcript. The alterations even included changing the language in a question that Julianna Balicka of KBW asked. The excuse of the company being rushed into responses does not apply to questions asked by research analysts. Why in the world would the substance of a question from someone outside of the company EVER need to be changed?

From KBW's Note on Sunday, November 1^st:

Unfortunately for management, "clarification under rushed circumstances" is not an excuse for bad behavior on a call. Legal counsel should have been present to make sure the company did not make "errors" due to "rushed circumstances". A company with strong internal controls and compliance does not find itself in situations that require edits due to "clarifications under rushed circumstances".

KBW has also now gone on record claiming that all allegations were "dismissed by regulators" in its note from Sunday night. FBR put out a similar note on Monday morning, also downplaying the transcript alterations. In fact, FBR actually put BOFI on its Top Ideas list.

Apparently, the bar for making the "Top Ideas List" at FBR does not exclude companies that modify transcripts and that discuss sensitive personnel information on public conference calls.

These sell-side firms have taken massive reputational risk with these notes. Should even 1% of the claims alleged in the lawsuit prove to be true, how will these firms defend the bold claims that they have made in their update notes?

Given that Davidson spoke with the company regarding the transcript alterations, I would be surprised if KBW and FBR - underwriters of BOFI's ATM offerings - did not do the same. If these firms did indeed speak with management regarding the transcript modifications, I wonder why these firms did not allude to any conversations with management in their update notes.

It is important to keep in mind that government investigations relating to claims of this magnitude take a substantial amount of time. The divisions of the OCC that look into enforcement issues are separate from the licensing division that covers M&A. Banks are also very fragile businesses - regulators need to be very certain of wrongdoing before going public, given that reputational issues for a bank have an impact on its solvency.

It is also worth noting that H&R Block (HRB) was represented by the high-powered law firm Covington & Burling LLP. Anyone who follows deal approvals knows that politics, personalities, and relationships often drive outcomes. In other words, enforcement proceedings could very well be ongoing despite the closure of the H&R Block deal. KBW's note also seems to ignore the fact that there could be a wide variety of federal agencies looking into BOFI (i.e., the OCC, SEC, IRS, etc.).

In my opinion, if KBW, FBR, and Raymond James were responsible and appropriately assessing conflicts of interest in this situation, they would have pulled their ratings on the stock given the uncertainty surrounding the company. Refer to a recent note by Aurelius for more information on potential conflicts of interest.

Part II - Start here if you are already caught up on the BOFI situation and are focused on the Employee Loans

If there was truly no basis to any of Erhart's accusations, BOFI would have had no issue hiring an outside audit firm to come in, conduct an investigation, and provide a clean bill of health. This should have occurred back in March 2015. However, from what I have seen, the company simply relied on an investigation conducted by some combination of Paul Grinberg (Chair of Audit Committee) and Eshel Bar-Adon (General Counsel). A company with nothing to hide should not only be unafraid of engaging an outside audit firm, but should do so with eager anticipation of a clean bill of health. In my opinion, as primary underwriters of BOFI offerings with due diligence liability, KBW, FBR, and Raymond James should have demanded that an outside firm provide a clean bill of health prior to issuing ratings on the stock.

I also want to get this out of the way right now before I dive into the insider loans. I am not Charles Erhart. I have never spoken to Charles Erhart by phone, email, or any other form of communication. I do not know Charles Erhart on any level other than reading information available online. I am not Carol Gillam. I have never spoken to Carol Gillam by phone, email, or any other form of communication. I do not know Carol Gillam on any level other than reading information available online. I want to make this clear because Mr. Garrabrants has been trying to create the false illusion of a short-seller conspiracy. I began looking into the glaring disclosure problems at this company long before Erhart's lawsuit. Seeking Alpha articles detailing the history of connections to stock promoters such as Tobin Smith and the weak disclosures around its lending practices were enough to get me interested in initiating a short position and conducting research.

While conducting research, the thing that really caught my attention was the incredibly low 1% interest rate that the company discloses on its related party mortgage loans.

In my opinion, the company's related party lending program provides crucial context for why this Board has been so silent and inactive in response to Erhart's claims... Hint: the Board members who SHOULD have been ordering investigations into Erhart's claims also happen to be some of the biggest beneficiaries of related party loans from BOFI. This is a clear conflict of interest, in my opinion.

First some background. BOFI discloses that it has an employee loan program. Since the passage of Sarbanes-Oxley, regulators have come down hard on favorable related party lending arrangements that are not done on an arm's-length basis. Banks have some carve-outs that allow them to make mortgage and education loans to insiders.

From the SFNC proxy, I found the following helpful summary of Regulation O:

Regulation O requires such loans to be made on substantially the same terms, including interest rates and collateral, and following credit-underwriting procedures that are no less stringent than those prevailing at the time for comparable transactions by the subsidiary banks of the Company with other persons not related to the Company. Such loans also may not involve more than the normal risk of repayment or present other unfavorable features. Additionally, no event of default may have occurred nor may any such loans be classified or disclosed as non-accrual, past due, restructured or a potential problem loan. The Company's Board of Directors will review any credit to a director or his affiliates that is criticized by internal loan review or a bank regulatory agency in order to determine the impact that such classification may have on the director's independence.

My interpretation of Regulation O is that related party mortgage loans must be made on similar terms to loans made to unaffiliated borrowers, unless they are part of a benefit/compensation program. If part of a benefit/compensation program, my interpretation of the accounting rules is that the below-market rate loans should be booked as a form of compensation.

You can read Regulation O yourself and develop your own opinions on the loans below. The analysis below is based on information that is publicly available (Zillow records, NextAce title records, county mortgage records, Bloomberg Law searches). I had to run the LTV math myself, but I have provided all the information you will need to do your own analysis of the loans provided below so that you can form your own conclusions. Again, I am making no claims about the legality of the loans below. I am providing public information to the market, and I encourage each reader to form her own opinion. Hopefully, lawyers familiar with Regulation O can opine in the comments section for the benefit of all investors.

The SEC asked BOFI about its insider lending program back in 2012 in this comment letter dialogue:

(Source: SEC Comment Letter)

When the SEC asked whether BOFI's insider loans are on the same terms as those prevailing at the time for comparable loans, the company claimed that they were, saying that while its insider rates were at below-market levels, the "loans were supported by more collateral than that normally provided by unaffiliated borrowers". The actual response BOFI provided makes little sense to me. In the first sentence, the company claims insider loans are on the same terms including rates and collateral as unaffiliated borrower loans. Then later in the same paragraph, BOFI admits that terms on insider loans are at below-market rates, while implying that they are market rates because they are supported by more collateral. So what is it? Are the loans market or not? Don't worry, my case does not rely on semantics (which I'm sure I'll get accused of in the below comments).

As a reminder, Garrabrants has adamantly insisted that unaffiliated BOFI borrowers have LTVs in the 50-60% range, on average. The analysis I have conducted is below, and seems to suggest that BOFI's original LTVs on insider loans are much higher than the 50-60% it claims to offer unaffiliated borrowers. The inception insider LTVs (based on my calculations) also appear to be very high relative to loans generally made during the comparable time frames.

My research into related party lending at BOFI suggests the following:

1. BOFI discloses in its 10-K that the average interest rate on its related party mortgage loan program is ~1.0% (through math shown below). My research suggests many of these loans were super-jumbo, and most had 80%+ LTVs and were made in the 2009-2012 time frame. This was an era when the jumbo mortgage market was in disarray, and when a 1% mortgage rate would have been unheard of for any unaffiliated borrower (regardless of a fixed or floating rate).
2. BOFI's assertion to the SEC regarding better collateral protection on insider loans does not look accurate to me, based on my review of the bank's insider loan LTVs at the time of origination.
3. The chairman of the Audit Committee (the individual who should be the watchdog for wrongdoing in the organization) has the largest related party mortgage I could find, and the terms look very favorable (80% LTV at inception).
4. BOFI General Counsel (Eshel Bar-Adon) has an elder sister. She has a BOFI loan in her name for a home in San Diego despite the fact that she appears to practice law in Texas... strangely, Eshel's signature appears in his sister's loan document, even though he is not listed as the borrower on the loan document. Political campaign contribution data suggests that Eshel is living in the San Diego home. According to Bloomberg law records, there was a "Notice of Federal Tax Lien" sent to Eshel Bar-Adon in December 2010 (about 2 years prior to the home purchase). Some readers may now be wondering why his Texas-based sister was the named borrower on a loan for a San Diego home that San Diego-based Eshel lists as his primary residence.
5. BOFI appears to have made an ~84% LTV purchase mortgage loan to its chief credit officer (who was a former bank regulator) in February 2012, despite the fact that he appears to have been underwater on an outstanding home loan at the time, and subsequently had a short sale on the underwater home in August 2012. I have a hard time believing that any bank would have made the February 2012 loan at that LTV, and with a balloon feature to an unrelated party, if it was aware that the borrower was underwater and nearing a short sale on an existing property.
6. The CEO of the company has a BOFI loan that appears to have been done at a >100% LTV at original inception - in 2009 - i.e., at a time when the mortgage market was in the midst of ruin.
7. BOFI does not appear to be booking the below-market rates on its loans as "other compensation", according to its proxy statements.

Here is an example from the FDIC's website which explains how Regulation O has been applied in the past with respect to below-market rate mortgages. I will let you decide yourself, after reviewing the loans contained herein, whether BOFI's loans would constitute multiple Regulation O violations.

I went through the most recently filed proxy statement (see below) and found no mention of any "other compensation" line item that would suggest the ~1% average rate loans are being captured in compensation expense. This is a big deal for banks - regulators have cracked down on insider lending over the past decades, because it is seen as an abusive practice that suggests weak internal controls and is often a precursor to bank failures.

Source of charts: BOFI Proxy filing

Summary of Loans to Insiders Found Based on My Analysis of Public Records

Unfortunately, the public loan documents I reviewed do not have individual borrower rates attached, so my analysis relies on the interest rate disclosed across the entire program (the 1% I calculated above). In other words, I cannot make any claims around the rates on individual loans. However, in a New York Times article, the CEO is quoted as saying that his average mortgage rates are just below the 5% range, which is substantially higher than the average rate of 1% the company reports in its financial statements.

The LTVs on individual loans are generally ascertainable using purchase price history and title record history. Obviously, I encourage readers to do their own work to arrive at the LTVs instead of solely relying on my analysis. The LTVs I calculated seem very surprising in light of the fact that many of these insider loans were originated during a time when the jumbo mortgage market was in disarray.

Here is an analysis of the underlying loans for individuals at the bank I could track down:

Paul Grinberg - Head of Audit Committee:

Paul Grinberg bought a home located in Orinda California (532 miles away from BOFI HQ).

(Source: Redfin)

I believe this is the same individual who is on the loan, given that his middle name matches his publicly listed middle name. See here.

The home was purchased for $2.74M in November 2012, and the loan was for $2.192M (implies an 80% LTV).

(Source: County Records)

This search appears to confirm this is the right Paul Grinberg.

Rama Bar-Adon (Eshel Bar-Adon):

Rama Bar-Adon appears to be the sister of Eshel Bar-Adon. She is listed as BOFI borrower. Google searches on her suggest that she practices law in Texas.

I had real issues with this loan, because the documents filed with the county look so bizarre on their face. Eshel is not listed as a borrower at the top of the loan document. Rama is the only borrower listed. Even though she is the borrower on the loan, Eshel's name and signature appears later on in the loan document. His name is even crossed out in certain places where placeholders were left for him to sign.

The home associated with the loan is in San Diego, yet Rama's primary area of legal practice appears to be Texas. The question, then, is whether Eshel is living in this home or whether Rama is living there. According to Virginia Department of Elections campaign contributions, Eshel was living in the home as of January 2013:

The fact pattern, as I see it, is as follows: Rama buys the house in December 2012 for $1.17M, with a 936k balloon loan from BOFI (80% LTV).

(Source: Redfin)

Note that Rama is the only borrower listed at the top of the document:

(Source: County Records)

On the loan document, Eshel (BOFI General Counsel) is listed in the signatory section, but his name was then scratched out mysteriously:

(Source: County Records)

Source: County Records

But then later on, his signature re-appears as a co-borrower on the Balloon Rider Page:

(Source: County Records)

I found the document below on a Bloomberg Law search for Eshel Bar-Adon as of 2010:

(Source: Bloomberg)

I believe this is the correct Eshel Bar-Adon. On his LinkedIn, Eshel says he previously worked at SenecaOne, a structured settlements company. The company is based in Maryland:

Furthermore, an Intellius search connects Eshel Bar-Adon to San Diego, CA, Gaithersburg, MD, and Rama Bar-Adon:

(Source: Intellius)

Who is living in this house / paying the mortgage? Why was the GC's sister a borrower on what appears to be a favorable terms loan made to a home that the GC of BOFI has listed as his residence? Would someone with a fairly recent history of a federal tax lien generally qualify for a favorable rate employee loan mortgage?

Thomas Constantine - Chief Credit/Regulatory Officer:

Thomas Constantine purchased a home in October 2006 for $800k.

(Source: Redfin)

Using NextAce title records, I looked into Constantine's borrowing history on the loan.

He initially put 640k of debt on this home. In 2007, he then took another 80k of debt out on the home. So, he had a total of 720k of debt on the home at peak (assuming no principal paydown).

In August 2012, he sold the home for ~450K.

(Source: NextAce title record)

According to Redfin, the August 2012 sale was a short-sale situation. If the August 2012 sale was indeed a "short sale", it could have influenced Constantine's credit, calling into question how he could qualify for an employee loan.

Source: Redfin

While he was potentially underwater in this Oceanside home, BOFI made him a balloon loan in February 2012 to go out and buy a home in Poway, California.

Constantine, through his family trust entity, paid $775k for a home in Poway, CA.

Source: Zillow

He appears to have received a $648K loan from BOFI that includes a "balloon rider" (i.e., this is some form of deferred principal payment / interest-only loan). So, the effective LTV at the time of the purchase, based on my calculations, was 84%. BOFI appears to have issued the loan on the Poway property at the same time that the Oceanside home was underwater.

If my interpretation of this situation is accurate, I have a hard time believing that an unaffiliated borrower who was underwater on an existing loan would qualify for an 84% loan from the bank.

Nicholas Mosich - Vice Chairman of Board:

Buys a house in July 2013 for $1.265M. BOFI loan from 7/11/2013 is $985K... works out to a 78% LTV.

(Source: Zillow)

(Source: County Records)

Gregory Garrabrants - CEO (through the Apollo Trust entity):

Garrabrants, through the Apollo Trust entity, bought a property on 10/30/2009 for $1.623M - public record:

(Source: Zillow)

Initially, he took out a 1.853M loan for his $1.623M property purchase. Then, around a year later, he refinanced the loan for a new $1.87MM loan. Keep in mind that these loans were made in 2009-2010, i.e., during the depths of the financial crisis.

Garrabrants' original loan is as below:

(Source: County Records)

And the refinanced loan is below, too:

(Source: County Records)

Ted Allrich - Chairman of the Board:

The chairman of the Board took a $600k construction loan as of 6/18/14 - here is the property in question. I do not know what the rate or terms on this loan were, or how to think about LTV, so I am just providing the document.

(Source: County Records)

Brian Swanson - Chief Lending Officer:

The chief lending officer bought a property in December 2010 for $711K. He took out a loan from BOFI in January 2011 (2-3 months later). Given only 3 months later, it is probably fair to say that this was still an 80% LTV at the time of issuance.

(Source: Zillow)

(Source: County Records)

Andrew Michelleti - Chief Financial Officer:

Michelleti has owned a home in La Jolla since 1993 (title records suggest he bought the home in September 1993 for $550k).

(Source: Zillow)

Michelleti appears to have received a cash-out refinancing loan from the bank for $1.5M in June 2011. It is a balloon loan. At the time, the terms of the loan would have been quite aggressive, to say the least (the jumbo balloon mortgage market was far from active in June 2011).

(Source: County Records)

Jim Argalas - Board of Directors:

In February 2013, Argalas took out a $1.5M loan from BOFI on this apartment:

The effective LTV is hard to determine, given that the home was last sold for $2M in 2007. Zillow estimated the home value at $2M.

(Source: County Records)

According to this website, Jim Argalas is based in San Francisco, which is the same city in which this loan is located.

Conclusion

All original loan documents are accessible on Property Radar.

I hope BOFI's auditor (BDO USA) conducts a full forensic investigation into the company's disclosures around related party lending. I also hope the company provides enhanced disclosure around its related party loans.

In the event that any BDO investigation results in findings that conclude BOFI's disclosures were inadequate relating to insider loans, I would assume that BDO will need to immediately either (A) order a restatement and full forensic review of historical financials, or (B) step down as auditor.

You, as a reader, can decide whether you think these loans are violations of regulations or not. One thing is clear - a 1%, on average, interest rate on mortgages for directors and officers is clearly insanely off-market (regardless of LTV or a fixed/floating structure).

So, if you, like me, are wondering why this bank never hired an external auditor to investigate recent allegations - perhaps these loans give us all a taste for the culture of compliance at this company.

And guess what? The retaliation lawsuit made no mention of related party loans. I think this article provides strong evidence that Greg's claims around some conspiracy are unfounded. I dug all of this up through simple public records and legal records searches.

So there you have it - yet another reason why any investor in this stock needs to start asking questions about how much they really know about BOFI. Hopefully, the sell-side analysts that have recklessly defended this stock take a hard look at this note and come to their own conclusions as well.

One closing thought. While the sell side has been quick to publish notes that declare a clean bill of health due to some supposed ambiguous "statement" by Jonathan Ball, why have none of them asked why a former regulator with extensive bank examination experience who had been at BOFI for over 4 years left in June 2015 as these issues started unfolding?

(Source: LinkedIn)

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.