The subprime lending industry was starting to buckle under the weight of bad loans in November 2006, when executives at Irvine-based New Century Financial Corp. held a conference call to release their latest earnings.
Loan volume was down and defaults were up, the earnings report showed, and in recent weeks at least five stock analysts had downgraded the company's shares. Moreover, four executives had sold nearly $20 million in stock in the last four months, six times as much as they had sold over the previous 12 months.
That led one analyst to ask whether there was anything investors should know.
"It's just part of their personal financial diversification plan," Chief Executive Brad A. Morrice said in response to the question during the Nov. 2 earnings call.
Those executive stock sales, however, have emerged as a central element in the Justice Department's criminal investigation of New Century, according to a person familiar with the inquiry who was not authorized to speak publicly.
No charges have been filed, and attorneys for the company's former top executives say that none of the executives sold stock based on information that had not been disclosed to the public and that the executives retained most of their shares when the company went under.
"Their stock sales were modest -- and entirely appropriate -- steps to diversify their assets," said John Spiegel, a Los Angeles attorney who represents five former New Century executives. "Any suggestion to the contrary simply flies in the face of the facts."
Justice Department officials declined to comment on their investigation of New Century, which collapsed into bankruptcy in early 2007 after a short-lived reign as the nation's biggest subprime lender.
The Times conducted its own review of the executive stock trades, analyzing Securities and Exchange Commission filings detailing 277 stock purchases and sales from 2003 to 2007 by six top executives.
Among other things, The Times looked at the executives' use of trading plans to sell stock, mostly after exercising options to buy at a low price and then sell at a much higher price. Federal regulators sanctioned use of such plans in 2000 as a way for executives to engage in regular sales of stock without being accused of making trades based on inside information.
To be an effective shield, however, the plans must be designed and executed carefully, securities experts say.
Although the trading plans themselves do not have to be disclosed publicly, executives routinely disclose when a sale is made under a plan. By reviewing these disclosures, as well as the plans for two of the executives, The Times found that:
* Company founders Robert K. Cole and Edward F. Gotschall adopted trading plans in June 2006 and then started new ones less than a year later, amid rising loan defaults. Between June and September 2006 alone, the rate of loans that were delinquent more than 60 days climbed nearly 30%.
* Cole adopted a trading plan on Sept. 15, 2006, and sold 25,000 shares under it the same day. Two other executives, Chief Financial Officer Patti M. Dodge and Executive Vice President Kevin Cloyd, sold stock within a week of setting up their plans in February 2005. Legal experts say making trades so quickly after a plan is adopted weakens the protection offered by a trading plan, because prosecutors or shareholder attorneys could argue that the plans were drafted to facilitate a quick dumping of shares.
* All six executives either enacted plans or made trades on the same dates as other executives, which legal experts say could raise questions about whether they were acting in concert on inside information.
* The trades do not appear to follow regular patterns. Over two years, for example, Morrice made only two sales under his trading plan -- and both were in July 2005, allowing him to sell $6.4 million worth of stock before the price fell about 40% later that summer.
Typically, trading plans call for executives to sell a set amount of shares each month or quarter, experts say, and executives usually stick to the same plan for at least a year.
"Any time there is a change in the trading plan, that raises a red flag," said Andrew Stoltmann, a Chicago securities attorney who advises firms on stock trading. "If you put on top of that a share price that's declining and a company that is soon to go into bankruptcy, prosecutors can have a field day with those sorts of facts."
New Century was founded in 1995 by Cole, Gotschall and Morrice, who had worked together at Plaza Home Mortgage in Santa Ana. Selling high-cost loans to high-risk borrowers, they built a subprime lending empire with more than 240 offices in 35 states and more than 7,000 employees, commanded from a high-rise in Irvine.
Fueled by the housing boom, the company's share price closed at an all-time high of $65.14 on Dec. 15, 2004. But it was downhill from there, as New Century and other subprime lenders suffered rising defaults and reduced demand.
In March 2007, New Century disclosed in an SEC filing that federal investigators were "conducting a criminal inquiry under the federal securities laws in connection with trading in the company's securities, as well as accounting errors regarding the company's allowance for repurchase losses." Then, on April 2, it filed for bankruptcy protection.
Government investigators have not spoken publicly about the probe since, but former prosecutors and others say the Justice Department is under renewed pressure to bring cases in the wake of the controversial $700-billion rescue plan for the financial industry. Public outrage over the bailout could lead to "a tidal wave of cases that we are going to see across the entire spectrum of the financial industry," said Dan Small, a former federal prosecutor who now works for law firm Holland & Knight in Boston.
Attorneys for the six former New Century executives say their clients believed through late 2006 that the company would make its earnings targets. The executives' faith in the company, they added, was bolstered by interest from Merrill Lynch & Co. and other firms in buying New Century at a significant premium over its share price.
But the examiner hired to review the company's finances by the U.S. Bankruptcy Court said New Century's troubles had surfaced by 2004.
"New Century knew from multiple data sources that its loan quality was problematic, starting no later than 2004," examiner Michael J. Missal wrote in his report this year, adding that "senior management before 2006 took few steps to address the troubling loan quality trends."
For example, the proportion of borrowers who had failed to make payments in the first three months of a loan reached 10% by November 2004 -- up from 4.2% in March, according to an internal report filed in a federal lawsuit against New Century by the New York State Teachers' Retirement System.
In 2004, Executive Vice President Stergios Theologides was the only senior executive with a trading plan. By early 2005, after the stock price had peaked, all six of the executives had adopted trading plans.
Unlike Theologides, who had methodically made sales of roughly the same amount over the previous two years, the other executives made trades infrequently, with wide variations in the amounts of shares sold.
"Under these trading plans, you would expect to see a pattern of sales," said David Nolte, a forensic accountant with Fulcrum Inquiry in Los Angeles, which performs investigative audits for government agencies and law firms. "That's not the situation with New Century. That's why, if prosecutors wanted, they could draw a distinction between a plan that is legitimate and a plan that is a ruse."
Dodge, the chief financial officer, set up her plan on Thursday, Feb. 17, 2005, and sold one-fifth of her holdings the following Tuesday. She exercised stock options that allowed her to buy shares between about $5 and $9 for a total of about $56,000 and sell them at $50 for nearly $350,000.
Gotschall, the board vice chairman, also set up a plan Feb. 17. He made his first sale under that plan June 8: 100,000 shares for $5.2 million. He did not use that plan for any other sales. Instead, he started a new plan in May 2005 and sold shares on two days in September for about $3.2 million.
Gotschall adopted a new plan in June 2006 and another in November 2006. Although retired from his job as chief financial officer, he continued to serve on the board of directors. Cole adopted seven plans in 2005-06. He retired as CEO in June 2006 but remained chairman of the board.
Manny Abascal, Cole's attorney, said his client changed plans so often because he was setting different floor prices for the stock to ensure that he did not get rid of his shares too cheaply. In some cases, that actually prevented him from selling stock. For example, he was unable to sell 50,000 shares in November and December 2006 because the share price never hit $40.
"These plans are flexible and can be changed when circumstances change, and there's nothing wrong with that," said Abascal, who is with law firm Latham & Watkins in Los Angeles.
But Small, the former prosecutor, said changing plans defeats the purpose of having one.
"The whole point of those plans is to have them in place and being executed on a regular, routine basis," Small said.
By early 2006, the company was seeing a huge increase in the amount of claims from investors who had bought New Century loans and now wanted their money back.
Typically, investors make these demands when borrowers miss payments. Such claims more than doubled in less than six months, from $75.3 million in January 2006 to $151.2 million in May 2006, according to internal company documents filed with the teachers' lawsuit.
Spiegel and Abascal have moved to dismiss that suit, saying the trading plans eliminated the potential for insider trading. A ruling on that motion is pending.
The two attorneys say their clients were bullish on the company, noting that Cloyd, Dodge and Morrice continued to buy shares into late 2006. Morrice and Cloyd bought more shares than they sold in 2006. The attorneys cited a March 2006 offer from Merrill Lynch to buy New Century at about $55 a share, when the stock was trading in the mid-$40 range. The offer was rejected.
In June 2006, Dodge, Cole and Theologides -- who hadn't traded for nearly a year -- adopted new trading plans that allowed them to kick-start their stock sales. Gotschall also adopted a new plan that allowed him to ramp up sales.
Together, the four executives sold nearly half a million shares from July to October 2006. By comparison, in the 12 months from July 2005 to June 2006, only Gotschall sold any shares, a total of 75,000.
Cole sold $4.7 million worth of shares, or about 7% of his stake in the company, on Aug. 7, 2006, under one of his plans.
He had a second plan at the time but never used it, according to his attorney. Instead, on Sept. 15, Cole adopted four new plans -- one to cover stock sales for each of the next four months.
These plans authorized a sale of 25,000 shares immediately and another 25,000 shares three weeks later. Cole reported selling the shares for $2 million.
"If it looks like you are adopting it and trading the same day or shortly thereafter, it looks like you're just making a bet on current information," said David Priebe, an attorney with DLA Piper in East Palo Alto who helps set up trading plans.
Abascal said the decision to sell Sept. 15 was made by Cole's broker, who was operating under a 14-day trading window and picked the first day that the stock price was above $40.
By the time of the Nov. 2, 2006, earnings call, New Century's financial footing had worsened, with the company reporting that the rate of people failing to make their first loan payment had nearly doubled from 2005.
Morrice said New Century would adopt tougher lending standards in hopes of curbing defaults, but added that "the impact to our overall results is not expected to be significant."
Investors kept heading for the exits, driving New Century shares down to $37.23 on Nov. 17, from more than $50 six months earlier.
On Nov. 18, Gotschall adopted a new trading plan, his fourth in less than two years. Two days later, on Nov. 20, he sold about $2.4 million worth of stock under that plan.
On Nov. 21, Gotschall sold nearly $5 million in stock after exercising about 75% of his remaining options, also under that trading plan.
Spiegel, who is with law firm Munger, Tolles & Olson in Los Angeles, said Gotschall's June 2006 trading plan called for him to sell stock just days before the Nov. 2 earnings release -- and a sale just before that disappointing report might draw criticism. As a result, Spiegel said, Gotschall adopted a new trading plan, which allowed him to push the sales back a few weeks.
Securities experts, however, said that whatever the motivation -- good or bad -- changes to trading plans undermine their purpose.
"The whole idea is you don't have any control over your sales, and if you go in and make changes or make other sales, then you are back in control," said Thom F. Carroll, a financial planner with Carroll, Frank & Plotkin in Baltimore. "You're now changing the rules to meet your needs, and it's not a trading plan under that safe harbor. It's whatever I want to do whenever I want to do it."
Within three months of Gotschall's November sales, New Century shares lost 50% of their value. By March, the company had collapsed and trading in its shares was halted by the New York Stock Exchange.
(BEGIN TEXT OF INFOBOX)
A spotlight on stock trades at New Century
Before collapsing last year, New Century Financial Corp. said federal investigators were examining stock trades by its executives. Securities experts say regulators are likely to examine the executives' use of trading plans.
Former executive vice president
Adopted a trading plan on Feb. 18, 2005, and made two sales under it, one for 5,000 shares at $250,900 on Feb. 22 and the other for 3,750 shares at $192,188 on June 30.
Bottom line: $443,088 in stock sales from February to June 2005.
ROBERT K. COLE
Former chairman and chief executive
Adopted a trading plan on March 9, 2005, and made one sale under it, selling 250,000 shares for $11.6 million on May 9.
Adopted two new trading plans on June 15, 2006, but used only one of them, making one transaction under it to sell 100,000 shares for $4.7 million on Aug. 7.
Adopted four new trading plans on Sept. 15, 2006, one for each of the next four months. That same day, he sold 25,000 shares for $1 million under one of the plans. Three weeks later, on Oct. 6, he sold 25,000 shares for $1 million under a plan for that month.
Bottom line: $18.3 million in stock sales from May 2005 to October 2006.
PATTI M. DODGE
Former chief financial officer
Adopted a trading plan on Feb. 17, 2005, and sold 6,952 shares under it on Feb. 22 for $348,434. Made a second trade under the plan on March 15, selling 3,426 shares for $168,799.
Sold 6,878 shares for $356,349 on June 6, 2005, and 4,782 shares for $245,078 on June 30. She did not indicate whether the sales were under the Feb. 17 plan or a new one.
Adopted a new trading plan on June 12, 2006, and on July 18 sold 13,889 shares for $638,894 under it.
Bottom line: $1.8 million in stock sales from February 2005 to July 2006.
EDWARD F. GOTSCHALL
Former chief financial officer
and vice chairman
Adopted a trading plan on Feb. 17, 2005, then adopted a new one on May 6. On June 8, sold 100,000 shares for $5.2 million under the Feb. 17 plan.
On Sept. 8, 2005, he sold 32,800 shares for $1.4 million. A day later, he sold 42,200 more for $1.8 million. Both sales were executed under the May 6 plan.
Adopted a new trading plan on June 15, 2006. Under this plan, he sold 100,000 shares on Aug. 15 for $4.2 million, 20,000 shares on Sept. 1 for $759,400, 80,000 shares on Sept. 5 for $3.1 million and 100,000 shares on Oct. 2 for $3.9 million.
Adopted a new trading plan on Nov. 18, 2006. Sold 65,300 shares on Nov. 20 for $2.4 million and an additional 136,145 shares on Nov. 21 for nearly $5 million under that plan.
Bottom line: $27.7 million in stock sales from June 2005 to November 2006.
BRAD A. MORRICE
Former chief operating officer
and chief executive
Adopted a trading plan on Feb. 18, 2005. Sold 60,500 shares for $3.1 million on July 1 and 64,500 shares for $3.3 million on July 5, both under the plan.
Bottom line: $6.4 million in stock sales in July 2005.
Former executive vice president
Adopted a trading plan on Sept. 12, 2003, and sold 3,000 shares for $112,500 on Dec. 1, 2003, 3,000 shares for $146,220 on Feb. 17, 2004, and 4,000 shares for $196,800 on March 15, 2004.
Adopted a new trading plan on Nov. 11, 2004. Under this plan, he sold 5,000 shares for $260,500 on Feb. 10, 2005, and 5,000 shares for $231,550 on May 10, 2005.
Adopted a new trading plan on June 16, 2006. Under this plan, he sold 5,000 shares for $206,900 on Sept. 15.
Bottom line: $1.2 million in stock sales from December 2003 to September 2006.
Sources: Securities and Exchange Commission filings, Times research
(BEGIN TEXT OF INFOBOX)
Feb. 17-18, 2005: Four senior New Century executives -- Patti M. Dodge, Edward F. Gotschall, Kevin Cloyd and Brad A. Morrice -- adopt stock trading plans. Properly executed, such plans can shield executives against accusations of insider trading.
September 2005: An internal company report shows that the company's 80/20 mortgage loans from 2004 had quadruple the default rates of other loans. These loans allowed people to buy homes with no money down. The report was disclosed in a 2008 Bankruptcy Court filing.
January 2006: An internal company report shows that for 10 of 12 months in 2005, more than 5% of New Century loans were rejected by investors, exceeding internal targets, according to the Bankruptcy Court filing.
February 2006: An internal report, cited in a lawsuit against New Century by the New York State Teachers' Retirement System, shows that the delinquency rate for loans that are 60 days old or more has doubled since 2003.
May 2006: In one of the first signs of trouble in subprime lending, Ameriquest Home Mortgage closes 229 retail offices and lays off 3,800 employees. In a May 4 conference call with analysts, New Century Chief Executive Robert K. Cole is upbeat: "I think existing competitors like ourselves always feel good when a large company takes a third of its labor force out of the market."
June 12-16, 2006: Four senior executives -- Dodge, Gotschall, Cole and Stergios Theologides -- adopt new trading plans. From July through November, they will sell nearly $27 million worth of stock.
August 2006: More investors exercise their option to return New Century loans that have experienced late payments. The backlog of "repurchase claims" hits $312.9 million -- up 67% from January, according to an internal document filed as part of the New York state teachers suit.
Nov. 2, 2006: During a conference call with investors, Dodge says that the company's total loan loss reserves had risen to $240 million by the end of September, a 14% increase from the previous quarter. But when the company files its official earnings report with federal regulators Nov. 9, it discloses that the reserves have actually fallen 8.7%, putting the company in a weaker position.
Feb. 7, 2007: New Century reports that it has made serious accounting errors and underestimated the costs of numerous loan repurchase demands. It is forced to restate its earnings for 2006, revealing $268 million in previously unreported losses.
March 2, 2007: The company discloses that it is the subject of a federal criminal investigation by the U.S. attorney's office into its accounting methods and stock sales by executives. The Securities and Exchange Commission also is investigating.
April 2, 2007: New Century files for bankruptcy protection.
Source: Times research