SEC: Fraud hid souring loans

The Securities and Exchange Commission's fraud lawsuit against former Conseco Inc. executives Rollin M. Dick and James S. Adams focuses largely on how the company valued Byzantine financial instruments known as "interest-only securities" throughout 1999.

The SEC, though, is trying to cast its

Conseco in 1998 had spent $6 billion to buy Minnesota-based Green Tree Financial Corp., the nation's biggest mobile-home lender, and was trying to silence naysayers who thought it paid way too much for a business where borrowers were at great risk of default. The value of the interest-only securities was tied to the performance of the Green Tree loans.

"The complexity of the security in this case is a red herring, because of the simplicity of the manipulation," Daniel Gregus, assistant regional director of the SEC's Chicago office, told IBJ. His agency alleges the two men ordered the value of the securities changed in company records to wipe away the need to take massive charges to earnings.

Yet legal observers and former Conseco insiders aren't expecting an open-and-shut case, and say the suit, filed March 10 in U.S. District Court in Indianapolis, leaves unanswered a litany of questions.

Among them:

* Why did the SEC name Dick and former Chief Accounting Officer Adams as defendants but not former CEO Stephen Hilbert? Observers say Dick, 72, considered Hilbert, 58, almost Re a son and normally consulted with him on any important matter. The two men now lead Carmelbased Haverstick Consulting, where Adams, 44, also maintains an office.

* If Dick, Adams and other executives knew they were concealing massive financial problems, why weren't they unloading their stock? In fact, during 1999, Dick borrowed $19 million and Adams borrowed $7 million to increase their Conseco holdings.

* Does the SEC truly have its arms around the accounting issues, and can it prepare a case a jury could decipher?

"I think it is entirely possible there could be a big misinterpretation going on," said Walter Kirkbride, who served as a Conseco executive vice president and ran its investment business from 1987 to 1994. He said estimating what interest-only securities are worth is notoriously difficult and hinges on myriad factors, including the number of borrowers expected to pay off loans early and the number expected to default.

While Kirkbride said he doesn't believe Dick would have done anything improper, if he did, "it is impossible for Steve not to have known. It's possible he didn't understand, but it's impossible he didn't know."

The SEC's Gregus wouldn't comment on Hilbert or say whether the investigation, first disclosed by the company in August 2002, is continuing. The FBI, which is conducting a criminal investigation of similar accounting issues, also wouldn't comment.

Joseph Goldstein, a Washington, D.C., lawyer representing Dick and Adams, said he believes his clients will be vindicated, but declined further comment.

David Kleiman, an Indianapolis attorney representing Hilbert, said Hilbert has not been contacted by the FBI and has not had any contact with the SEC in more than a year.

Legal observers say investigators sometimes target second-tier executives first, in hopes those officials will offer incriminating information about the CEO in return for leniency. The government has used that approach in probes stemming from the collapse of other high-profile companies, including Mississippi-based WorldCom Inc. and Houston-based Enron Corp.

Often, those second-tier executives "are the only people who are possible witnesses against the top people," said Indianapolis attorney Richard Dust, a former assistant U.S. attorney and a former trial attorney for the Justice Department.

Legal backdrop

IBJ reported in January that the SEC was targeting Dick and Adams while nearing a settlement with Conseco. The completed settlement, announced the same day the SEC sued the former executives, included no fine or admission of wrongdoing.

The probe covers the same period as more than three dozen lawsuits filed by investors in spring 2000, after the company shocked Wall Street by announcing an earnings restatement that wiped out nearly 40 percent of 1999 profits. The restatement stemmed from writing down the value of interest-only securities.

The investor fraud suits, which were later consolidated into a single case, charged executives had cast the company's performance in a positive light at a time financial woes were mushrooming. Without admitting wrongdoing, Conseco two years ago settled for $120 million. It was the 14th-biggest settlement since Congress overhauled the securities law in 1995, according to the Securities Class Action Clearinghouse at Stanford University.

That litigation included spectacular allegations, including that Hilbert stood over the shoulder of a Green Tree employee as the employee systematically doctored loandelinquency rates in order to conceal the unit's problems.

But many of the allegations were based on anonymous sources. And in a response filed at the time, Conseco said it had tracked down those sources, who denied making the statements. "The employees to whom those allegations are attributed (via pseudonym) completely disavow them," the filing said.

The filing continued: "Yes, Conseco made a mistake. The 1999 restatement acknowledges that. But the mistake occurred in projecting future cash flow from hundreds of thousands of loans, issued for billions of dollars and extending many years into the future.

"A mistake in a calculation this complex does not, on its face, suggest fraud, and the only way the plaintiffs are able to allege fraud is through improper 'unnamed source' averments that are neither statutorily permissible nor true."

In that suit, Conseco and current and former executives had the same attorneys. But during the SEC investigation, Conseco parted ways with Dick and Adams, who hired separate counsel.

The SECs case

The SEC seeks to recover from Dick and Adams their 1999 compensation, as well as other, unspecified, damages. Dick that year earned $4.1 million in salary and bonus and Adams earned $1.6 "Ilion.

The agency's 19-page suit rolls out allegations against the pair not contained in the investor litigation. Specifically, the SEC says, in every quarter of 1999 Dick and Adams instructed Conseco's accounting department to go back and change the initial value, of basis, for interest-only securities.

Here's how the securities worked: After Conseco issued loans, it would put them into pools and sell them to investors, a process known as securitization. But it would keep for itself the riskiest sliverthe interest-only security, representing the right to receive income remaining after expenses were paid and after holders of the other securities were paid.

Under accounting rules, each quarter Conseco had to determine a current value for its interest-only securities; if that value was less than the basis, it had to take a charge to reflect the difference. By changing the initial value, the SEC says, the company was able to avoid taking charges.

In the same period, Dick and Adams improperly increased revenue figures listed on preliminary quarterly financial statements prepared by the accounting department, the SEC says. The changes "increased earnings in each of the first three quarters of 1999, and many were inconsistent with [generally accepted accounting principles] or lacked supporting documentation," according to the SEC.

In addition, in the fourth quarter Dick and Adams manipulated the computer models used to estimate cash flows, which had the effect of increasing the current value of the interest-only securities and eliminating the need to take a charge, the SEC said.

Throughout the period Dick and Adams ordered adjustments, the pair were signing and submitting quarterly financial statements to the SEC containing the false information, the suit says.

Kirkbride, the former Conseco executive, said there are instances where adjustments are entirely proper. If the SEC case goes to trial, he said, testimony probably will center on the rationale for the adjustments.

Profits up front

Throughout 1999, Conseco executives were under immense pressure to impress Wall Street, which had panned its April 1998 purchase of Green Tree, its first major foray outside the insurance business.

Conseco agreed to a stock swap that valued Green Tree shares at $45 each, or 55 percent higher than their close a day earlier. Green Tree's stock had flirted with $50 a share in 1997 before tumbling when the company announced more than $200 million in earnings restatements.

Conseco shares fell 15 percent the day it announced the purchase. On a conference call with analysts touting the deal, Hilbert said: "As we all know, Wall Street sometimes takes a day or two to be enlightened."

But the shares continued their downward drift, even after the company reported in the first quarter of 1999 that Green Tree's operating profits had doubled and that the loan portfolio had swelled 31 percent from the same period a year earlier.

The torrid growth, though, was rattling analysts. At the time, Green Tree was using a controversial-but permissible-accounting approach known as "gain on sale," which allowed it to book up front the entire profit it expected to reap over the life of the loans.

Critics said the approach encouraged Conseco to make overly rosy assumptions, since doing so immediately fattened profits. 'Me approach also encouraged the company to make as many loans as it could, possibly at the expense of lending standards.

Throughout 1999, Conseco officials said they were maintaining those standards, but analysts grew increasingly doubtful as rivals targeting similar customers began reporting bad-loan woes.

By booking profits up front, "a bunch of us thought they were pushing the [accounting] envelope beyond where they should have," Ira Zuckerman, an analyst with Connecticut-based Nutmeg Securities, said last week. "It was allowable. But whether it was accurate was more important."

Bowing to pressure, Conseco in September 1999 said it would not use gain-on-sale accounting for future loans, and would instead book those profits as it earned them. But the company said the change did not stem from any weakness surfacing in the lending business.

Executives were again upbeat in announcing full-year financial results in February 2000. During a conference call with analysts, Dick said: "We did an extensive audit of our so-called intangible assets, and have good news to report. As to the interest-only security, recent and projected cash flow performance of the loans backing the security support the conclusion that no adjustments should be made to the book value of the [interest-only] security."

On March 7, 2000, Hilbert offered further reassurance, saying in a press release: "The healthy operating performance trends posted by Conseco are continuing into the first quarter of 2000."

But just 24 days later, Conseco announced a $350 million restatement of 1999 earnings, which it said stemmed from a continuing review of the value of interest-only securities. Conseco also said it was putting the lending business up for sale. After receiving tepid interest, Conseco ended up holding onto the business until last year, when it was sold as part of the company's Chapter 11 bankruptcy reorganization.

Why the about-face? According to the SEC lawsuit, Conseco's outside accounting firm, New York-based PricewaterhouseCoopers, discovered Dick's and Adams' adjustments during its annual audit and deemed them improper. At the time, according to the suit, the accounting firm also told the board the company needed to beef up its internal controls.

A source knowledgeable about the board discussions at the time was puzzled last week by the SEC's characterization. The source said the board was under the impression the restatement stemmed from honest disagreements between Dick and PricewaterhouseCoopers over whether the company could use interest-only securities that gained in value to offset losses on those that declined.

Motive?

The SEC's Gregus said the large loans Dick and Adams took out through the late 1990s to buy Conseco stock gave them "a strong incentive to support the price of the stock." By the end of 1999, Dick owed $78 million in principal and interest on loans used to buy shares then worth just $44 million. Adams owed $21 million in principal and interest on loans used to buy shares then worth $11 million.

But the big bet on Conseco stock also can be interpreted an entirely different way.

In the investor litigation Conseco settled for $120 million, attorneys for the company had argued: "Tellingly, plaintiffs do not allege that the individual defendants sold any of their Conseco stock at a time they were allegedly inflating its value-on the contrary, they acquired millions of additional shares. That is irreconcilable with any intent to defraud."

Indeed, neither public trading records nor pending lawsuits turn up evidence that top executives at Conseco sold in advance of the stock's plunge. The stock ultimately ended up worthless. It was canceled when the company emerged from bankruptcy court in September.

In a statement to IBJ in October, Hilbert said: "I never profited even a single dollar through the sale of my Conseco holdings. ... I truly believed in Conseco, the company I founded and built-and still do."