Recent BOFI Court Filing Confirms Existence Of Undisclosed Subpoenas And Nonpublic Government Investigations

Summary

• While BOFI has repeatedly stated that it is unaware of ongoing government investigations directly related to the whistleblower, non-whistleblower investigative activity has not been ruled out.
• An important but under-recognized portion of the whistleblower's complaint are allegations concerning the existence of "many" undisclosed subpoenas and regulatory investigations.
• BOFI's recent court filings confirm the existence of undisclosed subpoenas, nonpublic government investigations, including OCC investigations. Potential disclosure violations as well a "nonpublic SEC investigation" that BOFI references are examined.
• BOFI's alleged receipt of an SEC subpoena seeking information related to a lending client that perpetrated a Ponzi scheme acts to corroborate the whistleblower's allegations concerning BOFI's dealings with criminals.
• The Ponzi scheme perpetrator had been publicly tied to an earlier borrowing fraud, which calls into question BOFI's firm-wide underwriting practices and compliance with the Treasury Department's anti-money laundering regulations.

Summary

While BOFI (NASDAQ:BOFI) has repeatedly stated that it is unaware of ongoing government investigations directly related to the whistleblower, non-whistleblower investigative activity has not been ruled out. BOFI's recent publicly available court filings confirm the existence of undisclosed subpoenas, nonpublic government investigations, including OCC investigations. This appears to corroborate the whistleblower's contention that BOFI has received "many" government subpoenas. Since contents of the relevant exhibits have been sealed, it is impossible to know the specific subject matter of the investigative activity. To be clear, it is also impossible to know if the investigations are ongoing or if they have concluded.

In addition, the whistleblower had specifically identified BOFI's alleged receipt of an SEC subpoena related to an investment adviser named ETIA, the perpetrator of a Ponzi scheme. The SEC's investigation into ETIA has been public for quite some time which, coupled with the SEC's own whistleblower protection laws, casts doubt on the nature of the "nonpublic SEC investigation" that BOFI mentions in its court filings. BOFI's loan to a Ponzi-scheme perpetrator also acts to corroborate the whistleblower's allegations concerning BOFI's dealings with criminals, while highlighting underwriting and regulatory risks.

At minimum, it appears substantial regulatory risks remain. Investors are encouraged to do their own due diligence into these factors.

Note: The author has no relationship of any kind with Mr. Erhart or his lawyers. This article is based entirely on publicly available documents. The court documents are publicly available on the federal PACER system. The case number is 3:15-cv-02353-BAS-NLS, BofI Federal Bank v. Erhart et al.

Background

Bank Of The Internet has been under intense scrutiny in recent weeks after its former internal auditor, Matt Erhart, filed a whistleblower protection lawsuit earlier this month. The lawsuit sparked increased concerns of undisclosed investigative activity by regulators.

Since the filing of the lawsuit, BOFI has repeatedly stated that it is not aware of ongoing regulatory investigations specifically related to Mr. Erhart's allegations. These statements were supported by BOFI's recent preliminary injunction filing which was highlighted by a Seeking Alpha author in an article, "BOFI Court Filing Confirms There are No Ongoing Whistleblower-Related Investigations". In the filing, BOFI stated that, "neither the SEC, nor the OCC or any other agency has notified BofI of any concerns based upon the allegations against BofI he asserted in his complaint and previously asserted to them." This statement has led many to sound the "all clear" siren in regard to the existence of regulatory investigations.

While BOFI has made clear that it is not aware of Erhart-related government investigations, whistleblower protections appear to be structured so that, by definition, BOFI would not be notified. The nuances of whistleblower protection law are beyond the scope of this article, but should be considered by those inclined to believe that all investigative activity has ceased.

Regardless, BOFI's public statements have, in my interpretation, not ruled out ongoing investigative activity that is not directly related to Erhart's allegations. This is an important distinction. It was quite telling, in my opinion, that BOFI chose to delete Mr. Garrabrant's statement regarding a potential OCC investigation that "there is nothing ongoing" from the altered transcript it filed with the SEC (see article By Real Talk Investments). This was followed by Mr. Garrabrant's apparent unwillingness to directly answer if he could "just confirm again that as of today you're not aware of any ongoing investigations by federal regulators in the BofI? (emphasis mine) on the most recent earnings call. This may be for good reason.

One of the important, but under-recognized, sections of Erhart's lawsuit relates to his allegations concerning heightened investigative activity. For example, his complaint (Page 9, 21-27) states that:

Plaintiff saw a BSA spreadsheet that identified many subpoenas, including from law enforcement agencies, grand juries, and even from the U.S. Department of the Treasury, of which OCC is a part. Furthermore, Plaintiff sat next to the Bank employee who received and logged in subpoenas, and heard comments about how many there were and how frequently the Bank was served with subpoenas.

While BOFI has denied many of the specific allegations included in Mr. Erhart's complaint, it has not, to my knowledge, publicly addressed his claims regarding the existence of "many" undisclosed subpoenas and regulatory investigations. Importantly, the investigative activity that Mr. Erhart references appears to be entirely unrelated to investigations originating from his own whistleblowing activities.

Whistleblower's Alleged Trove Of Documents And BOFI's Motion To Seal

While conducting what BOFI describes as "rogue audits", Mr. Erhart allegedly assembled a trove of digital files, screenshots, and emails apparently in an effort to document his claims. Having allegedly taken the information with him, BOFI subsequently hired a digital forensic firm to identify and retrieve documents from Erhart's computer and email systems. This was detailed in a supporting document to BOFI's recent motion, "Declaration of Matthew D. Armstrong", in which Mr. Armstrong (the forensic examiner) reports finding, among other things, that Mr. Erhart copied 1,208 BOFI files to a USB flash drive. Mr. Armstrong appears to have been able to recover and catalogue many of these documents, which BOFI included as exhibits to its court filing.

It appears that one of BOFI's objectives in filing its motion is to ensure that the contents of Mr. Erhart's files remain secret. BOFI says as much in its motion, arguing that "Erhart must be stopped as it is unknown what further information he plans to release". As part of its motion, BOFI filed six declarations (statements of involved parties) as well as a total of fourteen supporting exhibits. Not wanting some of the contents to become public, BOFI simultaneously made a motion to seal and/or redact portions of these supporting documents.

BOFI's Motion Confirms Existence Of Undisclosed Subpoenas And Nonpublic Government Investigations

In its motion to seal, BOFI argues that portions of its supporting documents should be sealed and/or redacted because they reveal nonpublic regulatory investigative activity. As BOFI's motion states (Page 5, 12-16):

Other file names evidence communications with regulators, which are nonpublic and not to be disclosed, per agency rules. (Id.) Similarly, file names containing the term "subpoena" evidence nonpublic agency investigations, which BofI is not permitted to disclose.

In addition, later in its argument, BOFI states (Pages 4-5, 27-2)

"the confidential information contains records identifying the existence (and, in some cases, the subject matter) of investigations by the OCC."

BOFI also included a table (pages 6-7) indicating the portion of each document to be sealed as well as the reason for sealing. One of the most frequent reasons BOFI offers for sealing a portion of a document is because it "reveals confidential government subpoenas".

A section of the table has been provided above as an example, and interested readers can view the remaining portion of the table in the publicly available court documents. In total, BOFI cites "confidential government subpoenas" as a contributing factor in nine separate instances, including sealing three exhibits in their entirety. In addition to subpoenas, BOFI cites the "existence and nature of confidential regulator communications" as a factor in sealing portions of five of its supporting documents.

Chief Risk Officer's Declaration Confirms Existence Of Subpoenas & NonPublic Investigations

BOFI's motion also includes a declaration from John Tolla, the Chief Governance, Risk & Compliance Officer for BOFI. In his declaration in support of BOFI's motion to seal, Mr. Tolla himself states that "file names containing the term "subpoena" evidence nonpublic agency investigations" (Page 3, 25-27)

In addition, Mr. Tolla's declaration in support of BOFI's motion for preliminary injunction includes a review of the various exhibits prepared by Mr. Armstrong (a portion of this section is shown above including court redactions). During this review, Mr. Tolla again confirms the existence of nonpublic investigations:

These files are Confidential Information because they are identical to files held at BofI, which I have personally reviewed and which contain nonpublic information, internal audit committee findings and reports, communications with regulators, and evidence the existence of nonpublic government investigations.

Subject Matter Of Investigative Activity Remains Uncertain

Since the records that relate to investigative activity have been sealed, it is impossible to know the subject matter of the government investigations. It is also unclear if the subpoenas relate primarily to conduct by BOFI's customers, BOFI's own conduct, or some combination. Each of these possibilities is problematic and underpins the heightened regulatory risks that BOFI appears to face.

BOFI's Disclosure Practices Appear To Violate Materiality Standards.

On the October 14th conference call, Mr. Garrabrants indicated that a nonpublic subpoena for an individual borrower is material, in his estimation. As he stated on the call:

So if I've got a New York Times reporter asking me about a subpoena for an individual borrower, how did he get that information? Because that's not public and it is material.

Interestingly, the SEC was reviewing BOFI's disclosure practices in regard to litigation as recently as May, 2015. The SEC's publicly available comment letter states:

we note that you have not provided financial statement footnote disclosures related to any litigation. Please tell us how you considered the disclosure requirement of ASC 450-20-50 related to each of the aforementioned complaints in addition to any other actual or threatened litigation in your filing

Referencing several civil cases, BOFI's response to the SEC states that it "concluded that these cases were not material under the standards described in Item 103, and did not present any other material issues for which disclosure".

In regard to the subpoenas, however, Mr. Garrabrants has clearly stated on the call that subpoenas are material. Per Item 103 of regulation S-K, issuers must "Describe briefly any material pending legal proceedings". As a result, BOFI may have violated its disclosure obligations. I also note that the prospectuses for BOFI's ATM offerings also fail to disclose any subpoenas. Thus, the sell-side ATM underwriters, who continue to issue favorable reports, may have liability in this regard.

SEC Subpoena And The Potential Existence of A Nonpublic SEC Investigation

The only subpoena that Mr. Erhart specifically identifies in his complaint is one that BOFI is alleged to have received from the SEC for information regarding an investment firm named ETIA. This subpoena is not disclosed in the company's SEC filings. The recent Seeking Alpha article addressed the subject and concludes that the "nonpublic SEC investigation" that BOFI makes reference to in its motion must be related to ETIA, and not BOFI.

This reasoning is flawed, however, because details of the investigation into ETIA have already been posted publicly for some time and, therefore, it hardly qualifies as a "nonpublic" investigation. ETIA was a Florida based Ponzi scheme that the SEC shut down in January, 2015. The action was posted publicly (link to the SEC's ETIA Complaint) and reported widely at the time. So, because the ETIA investigation is already public, the nature of the "nonpublic SEC investigation" that BOFI references is hardly clear.

In addition, even though BOFI says it has not been notified of SEC investigative activity related to the whistleblower's claims, SEC investigative activity into BOFI can't be ruled out. The commission's own whistleblower protection laws appear to prohibit the SEC from notifying BOFI of any investigative activity stemming from the whistleblower's allegations. Therefore, by definition, BOFI wouldn't be notified if the SEC was investigating Mr. Erhart's claims.

The subject of the "nonpublic SEC investigation" is further complicated by an August article, in which a Seeking Alpha author, The Friendly Bear, reported triggering the "law enforcement exemption" in response to a BOFI FOIA request that the author says he submitted to the SEC. While this response does not confirm or deny an investigation, it does tend to be suggestive of an ongoing SEC investigation. Further reading about the law enforcement exemption can be found in this article, "Why a 7(a) Exemption Response To A SEC FOIA Request Is Evidence of A Current Law Enforcement Investigation". It is important to note also that the same article had reported that SEC FOIA requests submitted prior to August did not trigger the law enforcement exemption. Thus, something appears to have changed in the SEC's positioning sometime during the summer.

BOFI's Loan To The Perpetrator Of A Ponzi Scheme Calls Into Question BOFI's Loan Diligence While Corroborating Whistleblower's Claims.

BOFI's loan to a Ponzi-scheme operator is an important case study that highlights elevated underwriting and regulatory risks that investors should be aware of. The ETIA Ponzi scheme was operated by Frederic Elm, who, according to the SEC, "misappropriated at least $2 million in investor funds to pay for a $1.75 million home, high-end home furnishings and other personal items such as automobiles, jewelry, and daily living expenses." BOFI is connected to the matter because it underwrote the mortgage which is registered to Frederic & Amanda Elm. (Link To Receivership Files). BOFI has historically contended that its lending customers are willing to pay higher rates because BOFI "can provide carefully thought-out loans that fit its customers' needs more quickly than other lenders". The Loan to Mr. Elm certainly fits this description.

_{The Former Elm House, Which is Still For Sale (link), Is Pictured Above}

A simple Google search reveals that Mr. Elm had apparently changed his name after being implicated in a previous fraud just five years ago. Then going by the name "Frederick Elmaleh", Mr. Elm was charged with defrauding the Canadian Government (link) in a scheme involving fictitious borrowers. Critically, this corroborates Mr. Erhart's allegations that he "was able to readily uncover information that many of the borrowers were criminals, even notorious criminals who put the bank at high risk for violating the Bank Secrecy Act's Anti-Money Laundering Rules". BOFI was asked about this topic on the October 14th conference call:

Julianna Balicka - Keefe, Bruyette & Woods, Inc. - Analyst

Okay. And then, final question, and I'll step back. Could you comment on the paragraph in this complaint about the plaintiff was able to readily uncover information that many of the borrowers were notorious criminals? That is such a colorful statement.

Greg Garrabrants - BofI Holding Inc - President & CEO

.......There were a couple of borrowers, maybe three, that subsequent to the time that we made the loan, had some involvement in either an investigation of some kind or some sort of criminal inquiry. These were all single family loans. Any of that information about those allegations of criminality of these few borrowers were not apparent at the time diligence was done on the loans...."

Mr Garrabrants contends that "information about those allegations of criminality of these few borrowers were not apparent at the time diligence was done on the loans." Really? Considering it took less than two minutes to identify a widely circulated 2008 news release detailing the previous fraudulent activities of Mr. Elm (related to fictitious borrowing, no less), Mr. Garrabrant's statement, at least in this case, appears to be inaccurate.

Enormous apparent underwriting deficiencies are also highlighted in receivership documents which state that, "The Receiver has traced the source of funds...To that end, funds in the amount of $731,439.37 used to purchase the Elm Home came from two Receivership Entities, Elm Tree Investment Advisors LLC and Elm Tree Investment Fund LP". So in other words, the Elm house appears to have been purchased directly by ETIA's commingled client investment fund. This appears to be a glaring error. How did BOFI's diligence (if it did any) not identify that the funds used to purchase the home came from an account apparently beneficially owned by Elm's clients? Even basic due diligence should have identified bright red flags regarding both the source of Mr. Elm's income as well as the source of his funds. While I am not an expert on the government's detailed Bank Secrecy Act and Anti-Money Laundering guidelines, it appears that the "identification of the nominal and beneficial owners of accounts" is a key element of all lending activity.

At minimum, it appears substantial regulatory risks remain. Investors are encouraged to do their own due diligence into these factors.

Note: The author has no relationship of any kind with Mr. Erhart or his lawyers. This article is based entirely on publicly available documents. The court documents are publicly available on the federal PACER system. The case number is 3:15-cv-02353-BAS-NLS,BofI Federal Bank v. Erhart et al.

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.