On November 10th, I published an article on Bank of Internet (NASDAQ:BOFI) which exposed how a network of boiler rooms, bad loans, and off-balance sheet maneuvers appears to have boosted BOFI's reported operating results while adding greatly to its risk profile. Readers are directed first to that article as this piece provides an update on subsequent factual findings.
As a brief review, the article examined BOFI's unique and previously undisclosed relationship with Quick Bridge Funding. Several incontrovertible facts were established:
- BOFI itself is originating small business loans in partnership with Quick Bridge.
- Many of the BOFI-originated loans have gone bad and are flooding the courts with defaults and collection actions.
- The company's executives have signed off on "bulk assignments" of these loans to an undisclosed, off balance sheet SPE named WCL Holdings I, LLC.
The arrangement has increased BOFI's reported loan originations and non-interest income while also removing the bad loans from its balance sheet and reported delinquency statistics. The article also provided circumstantial evidence indicating that BOFI may actually be financing WCL Holdings' purchase of BOFI's own loan originations. One of the key supporting points of this assertion was Quick Bridge's own press release stating that it had secured a $35 Million credit facility "with a Southern California bank."
BOFI Now Confirmed To Be Financing WCL Holdings I, LLC
Recently obtained evidence now substantiates the article's assertions and provides irrefutable evidence that BOFI is directly financing WCL Holdings. The below documents were obtained from California's public UCC database. Note that the second page of the UCC financing statement clearly states that WCL Holdings I, LLC is the borrower. As suspected, BOFI has extended credit to WCL which is collateralized by loans that BOFI itself has originated and transferred to WCL.
(Note: BlackRock Lending Group is an affiliate of Quick Bridge and has no affiliation with BlackRock, Inc. (NYSE:BLK), the large, well-known asset manager).
BOFI is now confirmed to be financing at least one undisclosed, off balance sheet SPE whose primary operating purpose is to purchase loans from BOFI. The fact that many of the loans have gone bad should only amplify investor concerns.
The arrangement appears simple; BOFI originates loans and sells them to WCL Holdings. WCL is able to purchase the loans from BOFI by tapping the credit facility that BOFI itself has provided to it. BOFI is able to shift loans off balance sheet (earning non-interest income) and replace them with a credit facility extended to WCL.
Applicable Accounting Standards Were Updated After Financial Crisis
The applicable accounting standards for this arrangement fall under FASB Statement No. 166, Accounting for Transfers of Financial Assets and No. 167, Consolidation of Variable Interest Entities. The FASB's statements on these topics were updated after the credit crisis in an effort to abolish the abuse of SPEs (especially by banks) to mislead investors. When introduced, FASB Chairman Robert Herz explained that the changes "address concerns about companies who were stretching the use of off-balance sheet entities to the detriment of investors," adding that the new statements "will provide better transparency for investors about a company's activities and risks in these areas." One partner at an accountancy also explained that:
For some banks, these changes will be significant, and may lead to increases in the number of non-current loans on their balance sheets. Any non-current assets that have been part of securitizations will have to be consolidated on banks' balance sheets, and reported as non-current in Call Reports and other reports to regulators. Thus, some banks will be required to make additions to their loan loss reserves by reducing a quarter's earnings and, in some cases, capital.
BOFI Appears To Be Violating FASB Accounting Standards
Expanded disclosure obligations were one of the key features included by FASB in the updated accounting standards. Statement No. 166 outlines clear requirements regarding disclosures when financial assets have been transferred and the transferor has continuing involvement. Because BOFI has provided a credit facility to WCL, the company has retained ongoing risk related to the assets it has transferred to WCL. Since "continuing exposure to the risks related to transferred financial assets" is a key consideration, BOFI's arrangement with WCL clearly appears to meet the definition of continuing involvement.
This triggers substantial disclosure obligations. As a Deloitte paper on the subject states:
Transferors must disclose (1) whether they provided financial or other support to the transferee (or its beneficial interest holders) that they were not previously contractually required to provide, including the primary reasons for providing the support, and (2) details of any arrangements that could require any future financial support. ...Financial statement preparers must also provide details about any SPEs involved in the transfer, including the nature, purpose, size, and activities of the SPE, and how it is financed.
As has previously been noted, BOFI hasn't even disclosed the existence of its relationship with Quick Bridge or WCL Holdings. The lack of disclosure, in my opinion, represents a clear violation of accounting standards. It also stands in contrast to many banks which offer lengthy disclosures regarding their securitization activities and dealings with variable interest entities.
In addition, unlike many of the company's other recently examined dealings with SPEs, there is a possibility that WCL Holdings may actually require consolidation. The process of determining whether an SPE should be consolidated remains fairly technical (under statement No. 167) but hinges on the terms of the agreement and the capitalization of the entity. Since the relevant factors are nonpublic, it is impossible for investors to fully evaluate the matter (which, in fact, explains why disclosure is required). However, if WCL is thinly capitalized, then BOFI may be required to bring the underlying loans onto its balance sheet which would have significant accounting implications.
BDO Entrusted To Evaluate BOFI's Accounting
As BOFI's independent external auditor, BDO is entrusted to evaluate BOFI's accounting practices. Investors have good reason to be concerned about BDO. Last week's article examined BDO's alarming history of audit failures which have included numerous PCAOB deficiencies as well as high profile accounting frauds perpetrated by BDO audit clients. In particular, the PCAOB identified that BDO had "failed to test whether certain unconsolidated joint ventures were VIEs, which would require additional disclosure and could be subject to consolidation." This is exactly the accounting issue at stake in BOFI's undisclosed dealings with Quick Bridge and WCL Holdings.
Investors and analysts who are inclined to belittle or dismiss these issues are encouraged to read the complaint filed following the Stanford Financial collapse. Having signed off on numerous "clean" audit opinions, BDO's blown audit of Stanford Financial relates specifically to the same FASB standards applicable to BOFI's dealings with WCL (Note: Fin 46 was updated by Statement No. 167). As the complaint alleges:
BDO USA was required to understand Stanford Financial Group's overall business model and the relationships between its affiliated entities. The FASB issued FIN 46 in the wake of the Enron scandal to require auditors to understand the "big picture" by considering the substance of relationships among related business entities to determine consolidation for financial reporting purposes. If BDO USA properly considered and applied FIN 46 when auditing its Stanford Clients, particularly SGC and STC, then BDO USA knew that Stanford Financial Group operated as a consolidated business enterprise whose sole purpose was to sell SIBL CDs. If, on the other hand, BDO USA utterly failed to consider and apply FIN 46 when auditing its Stanford Clients, then BDO USA's willful conduct constitutes another major audit failure.
BOFI's Mysteriously Missing Required List of Subsidiaries
With that backdrop, BOFI's mysteriously missing exhibit 21 becomes especially curious. The exhibit 21 is the required list of a company's subsidiaries that serves as the basis for consolidation. The updated list is required to be included as part of each 10-K and the vast majority of companies (even the Chinese RTOs) include the exhibit as part of their annual filing.
BOFI has never included this exhibit along with any of its 10-Ks. Instead, the company has included a tiny disclosure (buried on page 61) referencing that the subsidiary list can be found as an exhibit "to the Registration Statement on Form S-1 (File No. 333-121329) filed on December 16, 2004, and amended January 26, 2005; February 24, 2005, and March 11, 2005," which suggests that BOFI hasn't created any new subsidiary entities in over a decade. Even if that were true, the problem is that the exhibit 21 was not included (at least on EDGAR) as an exhibit to any of the S-1 filings that BOFI references (link to the S-1 filings).
Since BOFI appears to have never even disclosed the required list of its subsidiaries, it's hard to believe that BDO has appropriately audited and reviewed BOFI's consolidation principles. Meanwhile, investors are left completely in the dark as to what entities BOFI actually consolidates in its "Black Box" of financial statements. In fact, without the exhibit 21, it is impossible to determine what entities actually generate the earnings that BOFI reports and the sell side continues to tout. Instead of authoring farcical reports examining the completely irrelevant impact of a stock split, perhaps BOFI's sell side analysts should begin to conduct actual and long overdue diligence into these factors.
Investors are also encouraged to conduct their own due diligence into these factors.
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.
Additional disclosure: All information for this article was derived from publicly available information. Investors are encouraged to conduct their own due diligence into these factors. Additional disclosure: This article represents the opinion of the author as of the date of this article. The information set forth in this article does not constitute a recommendation to buy or sell any security. This article represents the opinion of the author as of the date of this article. This article contains certain "forward-looking statements," which may be identified by the use of such words as "believe," "expect," "anticipate," "should," "planned," "estimated," "potential," "outlook," "forecast," "plan" and other similar terms. All are subject to various factors, any or all of which could cause actual events to differ materially from projected events. This article is based upon information reasonably available to the author and obtained from sources the author believes to be reliable; however, such information and sources cannot be guaranteed as to their accuracy or completeness. The author makes no representation as to the accuracy or completeness of the information set forth in this article and undertakes no duty to update its contents. The author may also cover his/her short position at any point in time without providing notice. The author encourages all readers to do their own due diligence.