How alleged ‘Ponzi’ firm fell through regulatory cracks

Both the state’s securities and banking agencies argue that the other had primary jurisdiction over the company

In 2000, when he was serving as director of the state’s Bureau of Securities Regulation, New Hampshire Banking Commissioner Peter Hildreth was warned by a Lakes Region lawyer that Scott Farah’s Meredith-based financial services firm was actually engaged in a “Ponzi scheme.”

But despite the warning given to both banking and securities regulators over the years – and despite a $1 million securities restitution order in 2007 and a banking audit citing repeat violations in 2008 – along with various warnings to state and federal law enforcement authorities, Financial Resources Mortgage Inc. managed to continue its activities, slipping through various jurisdictional cracks, until it landed in bankruptcy court in November.

There it was again labeled the perpetrator of a “Ponzi scheme,” this time one that allegedly hoodwinked investors out of tens of millions of dollars.

Both the state’s securities and banking agencies argue that the other had primary jurisdiction over the company. Each accuses the other of refusing to cooperate. Securities Director Mark Connolly says the banking department has repeatedly refused to share its audits with his agency.

Hildreth, however, charges that Connolly’s bureau tipped off Financial Resources to a surprise audit in 2006, a charge that the securities agency adamantly denies.

“That certainly didn’t help the process any,” says Hildreth in repeating his charge about the tipped-off audit. He adds he still will not release audits to the securities agency for “a number of reasons,” but would not state any of them. (At deadline, Hildreth said he did plan to release some information on these audits in the near future.)

Besides, says Hildreth, “clearly, this is a securities matter.”

If Hildreth thought so, he should have alerted securities long ago, shoots back Connolly. “Look, this is not what the public wants or needs to hear,” Connolly says. “The public wants action from its regulators. If Banking is unable or unwilling to regulate its licensees like Financial Resources Mortgage Inc., we welcome the Legislature to give us the authority, if it so chooses.”

Besides, Connolly says, “We are the only regulators to have actually done anything [before the company shut down], and we are not the primary regulator.”

Bankruptcy details

Despite all the finger-pointing, it is possible that Financial Resources might have found a regulatory no man’s land, where its alleged transgressions were simply beyond any state regulatory authority.

Commercial mortgages are simply not regulated in New Hampshire, except after the fact — that is, after fraud is already found. The Banking Department finally forced Financial Resources, and its loan servicing company CL&M Inc., into Chapter 7 bankruptcy on Nov. 20, after numerous investors – who had believed they were being sold a secondary mortgage backed by property and were now holding worthless paper – filed suit.

Bankruptcy revealed that Farah borrowed at least $20 million of those funds in a personal loan, apparently hoping to get more investors to pay for what was owed to former investors. In the end, according to the bankruptcy trustee, more than 500 investors had been defrauded. The companies had some $82 million in loans on the books and zero in the bank.

The alleged Ponzi scheme – involving high returns promised to investors that could only be paid off by sucking in new investors with the same promises — allegedly dated back to 2005, according to the bankruptcy trustee. But records released by the Securities Bureau show that the phrases “Ponzi scheme” and “Financial Resources” were coupled together much earlier.

The Securities Bureau’s investigation began in March 2000 after a complaint by Steven Latici, a lawyer representing a Florida widow against Farah, his company – then named Financial Recourses and Assistance of the Lakes Region Inc. – and T. Gary Coyne, doing business as Coyne Associates.

Coyne, who is apparently no longer associated with Financial Resources, was allegedly working closely with the company at the time, using its letterhead and operating out of its office.

The widow, along with other investors, lent money that was supposed to be used to refinance specific commercial mortgages, but instead was commingled with Coyne and Farah’s companies’ general funds.

In April 2000, Latici wrote a letter to Christopher Lent, an attorney for the Securities Bureau, about Lent’s “suspicion” that the whole thing was a Ponzi scheme.

“I think the fact that Financial Resources failed to segregate the funds of its investors would clearly indicate that, in fact, they were operating a Ponzi scheme,” Latici wrote. In October 2000, Latici forwarded that letter to Hildreth, arguing, “I don’t think there is any doubt at all that Financial Resources and Assistance is issuing unregistered securities.”

But Hildreth – who left the securities bureau to become banking commissioner in September 2001 – tells NHBR that one of the hoodwinked investors was a “close relative, so I had to recuse myself from the thing.”

Therefore, he says, he had very little to do with the affair.

Even back then, the issue of jurisdiction was raised by Financial Resources attorneys. “My client does not deal in securities and is overseen and audited yearly by the bank Commissioner,” wrote Ruth Hall, an attorney for Financial Resources, who suggested that Securities go to the Banking Department for information.

“Financial Resources is a licensed first-mortgage banker and broker,” explained Jason Sullivan two weeks later. “As a bank, any securities by Financial Resources would be exempt from registration.”

Farah himself told securities regulators to back off, stating that by providing information to the agency, “I may be violating banking and/or confidentiality” laws and said that he had been through four different audits by the banking department.

Differing definitions

It’s unclear what Hildreth’s opinion was on the matter when he was securities director, but in November 2001 – two months after Hildreth left the agency to become banking commissioner – securities staff attorney Jeffrey Spill proposed a cease-and-desist order for Farah and Coyne’s operations, insisting that the notes issued were securities.

Coyne appeared to settle with regulators in May 2002, but the case against Farah continued for years. The following May, Spill, of the securities bureau, asked for the release of banking audits of Financial Resources, by Mary Jurta, at the banking department. (Jurta was a securities auditor involved in the Financial Resources case who had followed Hildreth to banking.)

Jurta replied that banking examinations were confidential. Though she seemed to leave some room to give securities regulators a chance to look at them, they were never shared, according to Spill. The following year, another Farah lawyer – Denis Maloney of the Concord-based law firm Gallagher, Callahan & Gartrell – put forth a long legal analysis of why mortgage notes were not securities.

“Whether deemed ‘preferred stock,’ a ‘note,’ an ‘account;’ or other name, such instruments were in effect simple promises to repay monies and do not rise to the legal status of a ‘security’,” wrote Maloney. Even if some securities were involved, reasoned Maloney, Farah’s company “is subject to annual and ongoing regulation of the NH Banking Department … thereby rendering protection under the federal and state securities laws unnecessary.”

This went back and forth until both sides reached a consent agreement in January 2007, when Farah admitted that he had been issuing securities since 1996 and agreed to pay a $20,000 fine and restitution to investors – an amount Securities Director Connolly estimates to be roughly $1 million.

‘Radar screen’

But by this time, Farah had set up a another method to channel money from investors, using CL&M as a mortgage originator and/or servicer and involving pooling the mortgages into various trusts.

It only became clear early in December that that millions of dollars were going though CL&M – into Farah’s account in exchange for a promissory note.

Both Hildreth and Connolly say they didn’t know this was happening, though looking back at the matter, Connolly attributes this to securities regulators targeting his operation. “When we took action on promissory notes, they morphed into this trust and mortgage thing to avoid securities regulation,” Connolly says.

While Connolly says that Farah was still on his bureau’s “radar screen,” he seemed to be no longer selling securities, and his agency heard no complaints.

CL&M, a mortgage originator and servicer, was clearly in the banking department’s jurisdiction, Connolly says. Complicating the matter is that Banking Commissioner Hildreth appeared to be pushing for greater jurisdiction in other situations where regulatory authorities overlap, such as in overseeing entities like

Hildreth cited a law giving him exclusive jurisdiction over such entities. Since was a division of East-West Mortgage Company, Hildreth claimed that the New Hampshire Real Estate Commission couldn’t regulate the Internet company resulting. The move resulted in a lawsuit by Realtors.

But in the Financial Resources case, Hildreth appeared to take a more narrow view, arguing that his agency only had the authority to be involved with residential mortgages, and not the commercial mortgages Financial Resources was dealing in.

For instance, in November 2008, his department conducted an audit of Financial Resources and found – according to a response by Farah obtained by NHBR – some 16 different issues, from working with unlicensed entities (presumably CL&M) to “using ‘commercial construction loan agreements’ for primary residence loans to failure to provide quarterly financial statements.”

All of these violations were cited before, yet Hildreth didn’t take action at the time because the company made so few residential loans.

“Most of the loans were commercial. Only 19 in total were residential. The problem with this company was not residential, but commercial,” Hildreth said.

Why didn’t the banking department go after the unlicensed servicer, CL&M?

“There were only four loans involved and they were returned,” says Hildreth, and given the problems the mortgage lending industry was dealing with in the midst of the recession, it didn’t make sense to bother with “just a few loans.”

But didn’t it make sense – given the violations and both Hildreth and Jurta’s previous familiarity with the company when they worked at the securities bureau – to determine whether all those commercial loans were residential loans?

Hildreth says that more information will emerge when he releases the audits. Besides, any wider problem was a securities matter. Hildreth says he himself inspected the records after the company shut down and saw one loan that was clearly a securities matter. To which Connolly asks, if Hildreth had any inkling that this was a securities issue, why wasn’t his bureau contacted earlier?

Hildreth says he did invite the bureau to join him in a surprise inspection of Financial Resources in 2006, but that the bureau’s Spill not only declined, but tipped off Farah’s attorney Maloney about the matter.

(Maloney has declined to comment on any aspect of the case).

Spill says he does not recall nor have any record of any such incident, adding: “In no way, as a state official, would I deliberately attempt to impede a banking examination.”

Hildreth says he has contemporaneous notes from Jurta of Spill’s voicemail to that effect, but was not able to produce them by NHBR deadline.

Connolly says Hildreth’s charge is an “incredulous statement to make and unnecessary. I find this situation to not be constructive.”

Whatever the reason, neither agency was really watching what was occurring with the loans being sold by Financial Resources to investors — the very area of where the multimillion-dollar alleged fraud was taking place. Since these deals were involved in commercial lending, they were outside of the realm of banking, according to Hildreth.

Since they were pooled into trusts, they might have been outside the realm of securities, though Connolly says he won’t know for sure until he has the information, some of which is in banking audits that thus far have not been released.

“We believe that we in our office have the regulatory tools to help investors, and that is one of the reasons we have gone to banking for information. But at the end of the day we have to talk with a common voice,” Connolly says.