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Case 1:07-cv-02298-BBM Document 35 Filed 07/03/2008 Page 1 of 73
IN THE UNITED STATES DISTRICT COURTFOR TIIE NORTHERN DISTRICT OF GEORGIA
ATLANTA DIVISION
IN RE NETBANK, INC.SECURITIES LITIGATION
Civil Action No. 1:07-cv-2298
Complaint - Class Action
Jury Trial Demanded
CONSOLIDATED AND AMENDEDCLASS ACTION COMPLAINT
Lead Plaintiff Robert A. Brown ("Plaintiff' or "Lead Plaintiff'), by and
through his undersigned attorneys, individually and on behalf of all other persons
similarly situated who purchased or acquired NetBank, Inc. ("NetBank" or the
"Company") common stock during the period March 16, 2005 through and including
May 21, 2007 (the "Class Period") and were damaged thereby, as and for his
Amended and Consolidated Class Action Complaint (or "Amended Complaint"),
alleges as follows:
Case 1:07-cv-02298-BBM Document 35 Filed 07/03/2008 Page 2 of 73
TABLE OF CONTENTS
1. NATURE AND GENERAL OVERVIEW OF THE CLAIMS .......... 4
II. BASIS OF ALLEGATIONS .................................... 10
III. JURISDICTION AND VENUE ................................. I I
IV. NETBANK, INC. - THE BANKRUPT CORPORATE ENTITY ....... 12
V. THE PARTIES .............................................. 18
VI. OTHER RELEVANT PERSONS AND ENTITIES .................. 23
VII. CLASS ACTION ALLEGATIONS .............................. 33
VIII. ADDITIONAL SUBSTANTIVE ALLEGATIONS .................. 37
A. Corporate History of NetBank ............................. 37
B. NetBank' s Business Segments ............................. 38
C. Overview of Bank Mortgage Lending ....................... 41
IX. DEFENDANTS' ADDITIONAL FALSE ANDMISLEADING STATEMENTS ................................. 44
A. NetBank's Surreptitious Transition From Its Core Banking
Operations to the Subprime Mortgage Market ................. 44
B. Defendants ' Sham Restructuring of NetBank ................. 74
C. Defendants Falsely Assure Investors That TheyCan Rely on NetBank's Book Value ........................ 86
D. Defendants Make Additional False Assurances
to Investors After E&Y Resigns ............................ 90
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E. NetBank Continues to Falsely Reassure InvestorsAbout the Company's Condition and Operations ............. 104
F. NetBank Misleads Investors Regarding the Validity
of Its FAS 133 Accounting ............................... 115
X. THE TRUTH REGARDING DEFENDANTS' FRAUDBEGINS TO EMERGE ....................................... 123
XI. GAAP VIOLATIONS ........................................ 139
A. Lack of Adequate Internal Controls ..... ................... 142
B. Understatement of Representations and Warranties Liability .... 162
C. Undisclosed Impairment of Goodwill ...................... 175
D. Overstatement of Mortgage Servicing Rights Valuation ........ 182
F. Ineffective Disclosure of Controls and Procedures ............ 186
XII. ADDITIONAL SCIENTER ALLEGATIONS ..................... 189
XIII. LOSS CAUSATION/ECONOMIC LOSS ........................ 191
XIV. FRAUD ON THE MARKET DOCTRINE ........................ 196
XV. INAPPLICABILITY OF SAFE HARBOR ....................... 199
CLAIMS FOR RELIEF:
COUNT I - Violation of Section 10(b) of the Exchange Act andSEC Rule 10b - 5 Against All Defendants ........ ....... 200
COUNT II - Violation of Section 20(a) of the Exchange ActAgainst the Individual Defendants .................... 205
PRAYER FOR RELIEF AND JURY DEMAND ........................ 206
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1. NATURE AND GENERAL OVERVIEW OF THE CLAIMS
1. This is a federal securities law class action brought against NetBank's
senior officers and directors, including Douglas K. Freeman, James P. Gross, Steven
F. Herbert, Thomas H. Muller, Jr., Eula L. Adams, David W. Johnson, Jr., and
Catherine A. Ghiglieri (collectively, the "Defendants").
2. During the Class Period, Defendants engaged in a fraudulent scheme to
artificially inflate the price ofNetBank's publicly-traded common stock, in violation
of the federal securities laws, §§ 10(b) and 20(a) of the Securities Exchange Act of
1934 (the "Exchange Act") and Rule I Ob-5 promulgated thereunder.
3. Plaintiff alleges, in sum, that Defendants defrauded Class members by
making materially false and misleading statements and omissions regarding the
financial results, operations and condition ofthe Company, which artificially inflated
the price of NetBank common stock during the Class Period. As a result of those
statements and omissions, the Company's stock traded at artificially inflated levels
during the Class Period -- trading as high as $8.74 per share on March 16, 2005.
However, by the end of the Class Period, the Company's stock had evaporated to a
mere $0.59 per share on May 21, 2007.
4. As the Country's oldest internet bank, NetBank claimed early successes
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in supposedly being transformed following its 2001 acquisition of Market Street
Mortgage Corporation, and its conservative line of residential mortgages. Shortly
thereafter, NetBank changed its conservative course when in 2002 it acquired
Resource Bancshares Mortgage Group ("RBMG"), and that entity's risky subprime
mortgage subsidiary, Meritage Mortgage Corporation. In connection with that
acquisition , RBMG's Chief Executive Officer ("CEO") and Chief Financial Officer
("CFO"), defendants Freeman and Herbert, assumed those same roles with the "new"
NetBank, ousting NetBank's more conservative CEO, D.R. Grimes.
5. At that time ofthe 2002 RBMG acquisition, NetBank's banking business
was only marginally pro f table. In a desperate and reckless effort to grow at all costs,
Defendants moved to then essentially transform NetBank into a high risk mortgage
company -- thereby abandoning the conservative mortgages favored by former CEO
Grimes and instead relying and expanding upon subprime and other risky mortgage
lending as the primary means of generating income from the Company's $2 billion
bank deposit base.
6. As a result, defendants Freeman and Herbert -- NetBank's "new"
management -- created a corporate culture that blindly focused its emphasis on
earnings growth and at least creating the impression that its products and services
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were revolutionary. In executing a plan to reinvent NetBank, Defendants essentially
attempted to leverage the Company's deposits with inherently risky subprime loans
and other business segments, in order to create the false impression that the
Company's efforts to diversify and capitalize on its banking deposits were successful.
7. In doing so, Defendants implemented a series ofpolicies, procedures and
practices that failed to comply with Generally Accepted Accounting Principles
("GAAP"), and thereby falsely portrayed the Company ' s earnings, overvalued its
mortgage assets, undervalued its subprirne exposures and misaccounted for its
hedging activities. NetBank's resulting misrepresentations and omissions were made
by, approved by and/or implemented by each of the Defendants, who include the
Company's senior operational officers and its Audit Committee.
8. Beginning in March 2005, NetBank filed with the United States
Securities and Exchange Commission ("SEC") the Company's 2004 Form 10-K,
which falsely reported not only the Company's financial results, but also its business
operations and corporate restructuring. Thereafter, Defendants made continuing
misstatements and omissions to the investing public, in which they claimed that the
Company was successfully restructuring and reporting properly its financial results
and condition.
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9. In May 2006, Defendants made a series of representations to the
investing public in which they claimed that NetBank was then successfully
restructuring its operations to eliminate high-risk non-conforming loan origination
operations and other failing business segments. These representations were highly
material and impacted the perceived value of NetBank's common stock, because the
Company also claimed that it had a strong core banking business that would
substantially benefit from the elimination of the high-risk, non-conforming loan
origination segment . The Defendants claimed that the restructuring was substantially
complete by February 2007. At that time, Defendants also represented that investors
could rely on the book value of the Company as an accurate reflection ofNetBank's
true value. Those representations were false.
10. On November 9, 2006, NetBank revealed that its outside auditor, Ernst
& Young (or "E&Y"), would be resigning after the Company filed its Form 10-Q for
3Q2006, which was then made on November 9, 2006. Although this information was
not previously made public, Defendants had known this since October 10, 2006.
Moreover, the Company and E&Y falsely claimed that no material disputes led to the
resignation . On February 16, 2007, NetBank announced that the Company had
retained a new outside auditor. Defendants falsely assured investors by stating that
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the filing of its 2006 annual report on Form l 0-K would simply be delayed as a result
of this transition.
11. On May 21, 2007, NetBank shocked the market when. it announced that,
contrary to its prior public representations, its core banking business was in fact
highly deficient and that the Company had failed to meet its regulatory capital
requirements. Netl3ank further disclosed that, as a result of this significant deficiency
in its core banking business, banking regulators were forcing the Company to
consummate a sale of its $2.5 billion of core and brokered deposits, its held for
investment loan portfolio, all of the assets and liabilities of NetBank Business
Finance, the Company' s small business equipment leasing and financing operation,
and the NetBank brand and related trademarks and service marks. NetBank reported
that the forced sell-off would result in a loss of $60-70 million . In. other words,
NetBank was being forced to liquidate at a loss its core banking operations and nearly
all of the remainder of its business segments. These disclosures were effectively
admissions that the Company's books and valuations were grossly overstated and
misstated, and that not only had NetBank failed to account properly for its mortgage
business but that even its "core" banking business was on the verge of collapse.
Unsurprisingly, as a result of these devastating disclosures, the Company's common
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stock price plummeted 66%, from $1.75 per share on May 18, 2007 to $0.59 per
share on May 21, 2007.
12. Thereafter, on August 6, 2007, NetBank filed a Form 8-K with the SEC
that reported that the entire carrying amount of goodwill for the Company's wholly-
owned retail mortgage business , Market Street, would have to be written off, resulting
in an impairment charge of $24.6 million.
13. NetBank then continued to claim that the transition to its new auditor
was delaying the filing of its 2006 Form 10-K, and even its Forms 10-Q for 1 Q2007
and 2Q2007. Indeed, since E&Y resigned in November 2006, NetBank failed to file
any of its requisite financial reports with the SEC. As a result, the NASDAQ
repeatedly threatened and ultimately did delist NetBank's stock on August 7, 2007.
14, On August 10, 2007, NetBank filed a Form 12b-25 which reported that
E&Y had withdrawn its audit opinions for the Company's prior Forms 10-K for 2004
and 2005, based on the Company's misapplication of Statement of Financial
Accounting Standard ("FAS" or "SFAS") 133, and that investors should no longer
rely on NetBank's financials. The Company also admitted that it had withheld the fact
that the SEC had been investigating the Company' s accounting practices since at least
August 31, 2006 -- nearly one year prior. Not only did Defendants fail to disclose
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publicly the SEC investigation, Defendants also failed to disclose that they were
unable or unwilling to correct NetBank's accounting and produce accurate financial
reports.
15. Ultimately, Defendants failed to file publicly with the SEC any financial
statements following the 3Q2006 results the Company filed in November 2006. In an
effort to conceal their fraud, Defendants also withheld making any financial
restatement for its prior financial results -- and allowed instead for the Company's
stock to be delisted, and for the Office of Thrift Supervision' ("OTS") to finally step
in and shut down NetBank's operations on September 28, 2007. By that time,
NetBank's common stock was rendered valueless, the Company sought bankruptcy
protection, and NetBank's investors had become fraud victims of the first bank
failure infiveyears, the largest bankfailure since] 993 and the largest bank failure
in the history ofthe State of'Geoxgia.
Il. BASIS OF ALLEGATIONS
16. Plaintiff makes the allegations herein, other than those concerning
himself, based upon the investigation of Plaintiff's counsel. Said investigation
' The OTS is the primary federal regulator of federally chartered andstate-chartered savings associations, their subsidiaries, and their registered savingsand loan holding companies.
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included a review of various filings with the SEC, press releases issued by the
Company, media reports concerning the Company, publicly disseminated documents
concerning the Company's business practices, securities analysts' reports and
advisories about the Company, pleadings and other documents filed in other
litigations involving NetBank, and certain other public filings and documents, as well
as interviews with former employees of NetBank (some of whom are referenced
herein as confidential witnesses). Moreover, the Company has admitted to certain of
the wrongful acts and practices alleged herein; those admissions also serve as a basis
for Plaintiff's allegations. Plaintiff believes that additional evidentiary support will
exist for his allegations after he is afforded a reasonable opportunity for discovery.
III. JURISDICTION AND VENUE
17. This Court has jurisdiction over the subject natter ofthis action pursuant
to Section 27 of the Exchange Act (15 U.S.C. § 78aa) and 28 U.S.C. § 1331. The
claims asserted herein arise under sections 10(b) and 20(a) of the Exchange Act, §
78j(b) and 78t(a), and SEC Rule lOb-5, 17 C.F.R. § 240.1Ob-5.
18. Venue is proper in this District pursuant to Section 27 of the Exchange
Act (15 U.S.C. § 78aa) and 28 U.S.C. § 1391(b) and (c). Many of the acts and
transactions giving rise to the violations of law complained of herein, including the
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preparation and dissemination to the investing public of materially false and
misleading information, occurred within this District, and NetBank maintained its
principal place of business in Alpharetta, Georgia.
19. In connection with the acts, omissions, conduct and other wrongs alleged
in this Amended Complaint, all. ofthe defendants, directly and/or indirectly, used the
means and instrumentalities of interstate commerce including the mail, the Internet,
interstate telephone cormnunications, and the facilities of national securities markets
and exchanges.
IV. NETBANK, INC. - THE BANKRUPT CORPORATE ENTITY
20. NetBank, Inc. was incorporated in the state of Georgia and maintained
its executive offices at 1015 Windward Ridge Parkway, Alpharetta, Georgia 30005.
a. NetBank was founded in 1996 and represented itself as a financial
holding company that operated a family ofbusinesses focused primarily on consumer
and small business banking. By 2007, at the time of NetBank's demise, the
Company's retail banking franchise, NetBank, FSB, was the nation's oldest active
Internet bank serving retail and business customers in all 50 states.
b. In addition to its core banking business, NetBank owned several
subsidiaries including: NetBank, FSB ("NetBank, FSB"), a federal savings bank;
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MG Reinsurance Company ("MG Reinsurance"), a captive reinsurance company;
Netlnsurance, Inc. ("Netlnsurance"), a licensed insurance agency; and NB Partners,
Inc. ("NB Partners"), a corporation involved in so-called strategic partnering
opportunities. Netbank, FSB owned, during all or part of the Class Period, all of the
outstanding common stock of: Market Street Mortgage Corporation ("Market
Street"), a retail mortgage company; NetBank Payment Systems, Inc. ("NBPS"), a
provider of ATM and merchant processing services for retail and other non-bank
businesses ; Meritage Mortgage Corporation ("Meritage"), a wholesale non-
conforming mortgage provider ; and Financial Technologies, One a provider
of transaction processing services to financial services companies. NetBank, FSB's
wholesale mortgage division operated as NetBank Funding Services ("Netbank
Funding"); its business financing division operated as "NetBank Business Finance";
its automobile financing division operated as "Dealer Financial Services"; and its
recreational vehicle financing division operated as "Beacon Credit Services."
c. As of February 21, 2007, there were 46,425,000 outstanding
shares of NetBank, Inc. The Company's shares were traded on the National
Association of Securities Dealers Automated Quotations ("NASDAQ") securities
exchange, an open and efficient market. The Company's stock traded on the
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NASDAQ, from 1997 until its delisting on August 7, 2007, under the symbol
"NTBK"
d. NetBarik had been named as a defendant in the initial class actions
captioned Adcock v. iVetBank, Inc., et cxl.,1:07-cv-02298-BBM (N.D. Ga.) and Vahdat
v. NetBank, Inc., et cil., 1 :07-cv-026 31. -BBM (N.D. Ga.). Under the Court's Order
entered in the instant proceedings on April 21, 2008 (Docket no. 32), those actions
and all other such class actions were consolidated. However, since the filing of the
Adcock action, NetBank filed for protection under Chapter 11 of the federal
bankruptcy laws. See In re llreiBank, Inc., No. 3:07-bk-04295-JAF (M.D. Fla. Bankr.,
filed September 28, 2007). In adherence to the automatic stay under the bankruptcy
laws (11 U.S.C. § 362(a)), NetBank has not been joined as a defendant in this
Amended Complaint.
21. During the Class Period, NetBank carried out a plan, scheme and course
of conduct which was intended to and, throughout the Class Period, did: (i) deceive
the investing public regarding the Company's business, operations, management and
the intrinsic value of NetBank securities; and (ii) cause Plaintiff and other members
of the Class to purchase NetBank's securities at artificially inflated prices. In
furtherance of this unlawful scheme, plan and course of conduct.
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22. NetBank: (a) employed devices, schemes, and artifices to defraud;(b)
made untrue statements of material fact and/or omitted to state material facts
necessary to make the statements not misleading; and (c) engaged in acts, practices,
and a course of business which operated as a fraud and deceit upon the purchasers of
the Company's securities in an effort to maintain artificially high market prices for
NetBank's securities in violation of Section 10(b) ofthe Exchange Act and Rule 1 Ob-
5 promulgated thereunder.
23. NetBank, individually and in concert with the Defendants, directly and
indirectly , by the use, means or instrumentalities of interstate commerce and/or ofthe
mails, engaged and participated in a continuous course of conduct to conceal adverse
material information about the business, operations and future prospects of the
Company as specified herein,
24. NetBank employed devices, schemes and artifices to defraud, while in
possession ofmaterial adverse non-public information and engaged in acts, practices,
and a course of conduct as alleged herein in an effort to assure investors of the
Company's value andperformance and continued substantial growth, which included
the making of, or the participation in the making of, untrue statements of material
facts and omitting to state material facts necessary in order to make the statements
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made about the Company and its business operations and future prospects in the light
of the circumstances under which they were made, not misleading, as set forth more
particularly herein, and engaged in transactions, practices and a course of business
which operated as a fraud and deceit upon the purchasers of NetBank's securities
during the Class Period.
25. NetBank had actual knowledge of the misrepresentations and omissions
ofmaterial facts set forth herein, or acted with reckless disregard for the truth in that
it failed to ascertain and to disclose such facts, even though such facts were available
to it . NetBank's material misrepresentations and/or omissions were done knowingly
or recklessly and for the purpose and effect of concealing the Company's operating
condition and future business prospects from the investing public and supporting the
artificially inflated price of its securities. As demonstrated by NetBank's
overstatements and misstatements of the Company's business, operations and
earnings throughout the Class Period, NetBank, if it did not have actual knowledge
of the misrepresentations and omissions alleged, was sufficiently reckless in failing
to obtain such knowledge by deliberately refraining from taking those steps necessary
to discover whether those statements were false or misleading.
26. As a result of the dissemination of the materially false and misleading
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information and failure to disclose material facts, as set forth above, the market prices
ofNetBank's securities were artificially inflated during the Class Period. In ignorance
of the fact that market prices ofNetBank's publicly-traded securities were artificially
inflated, and relying directly or indirectly on the false and misleading statements
made by NetBank, or upon the integrity of the market in which the securities trade,
and/or on the absence ofmaterial adverse information that was known to or recklessly
disregarded by NetBank but not disclosed in public statements by NetBank during the
Class Period, Plaintiff and the other members of the Class acquired NetBank
securities during the Class Period at artificially high prices and were damaged
thereby.
27. At the time of said misrepresentations and omissions , Plaintiff and other
members ofthe Class were ignorant of their fal sity, and believed them to be true. had
Plaintiff and the other members of the Class and the marketplace known the truth
regarding NetBank' s financial results, which were not disclosed by Defendants,
Plaintiff and other members of the Class would not have purchased or otherwise
acquired their NetBank securities,. or, if they had acquired such securities during the
Class Period, they would not have done so at the artificially inflated prices which they
paid.
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28. By virtue of the foregoing, NetBank violated Section 10(b) of the
Exchange Act, and Rule IOb-5 promulgated thereunder. As a direct and proximate
result of NetBank's wrongful conduct, Plaintiff and the other members of the Class
suffered damages in connection with their respective purchases and sales of the
Company's securities during the Class Period.
V. THE PARTIES
A. The Lead Plaintiff
29. Lead Plaintiff Robert A. Brown, a citizen and resident of Arizona,
purchased and/or acquired NetBank common stock during the Class Period at
artificially inflated prices and was damaged thereby. Attached hereto is a copy ofMr.
Brown's PSLRA certification that was filed previously in this litigation.
B. The Individual Defendants
1. Steven F . Herbert ("Herbert")
30. Defendant Herbert was, from the inception of the Class Period through
October 5, 2006, NetBank's Chief Financial Executive ("CFE") and a Director ofthe
Company. From October 5, 2006 through December 17, 2007, Herbert was replaced
Defendant Freeman as NetBank's Chief Executive Officer ("CEO"). Herbert signed
the Company's Forms 10-K for the years 2004 and 2005. He also signed Company's
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Forms 10-Q for the first, second and third fiscal quarters of 2005 (filed with the SEC
on May 10, August 9 and November 14, 2005, respectively) and Forms 10-Q for the
first and second fiscal quarters of 2006 (filed with the SEC on May 10 and August 8,
2006, respectively). As to each of the Forms 10-K and 10-Q that Herbert signed, as
well as NctBank's Form 10-Q for the third fiscal quarter of 2006 (filed on November
9, 2006 ), he also signed a Certification Pursuant to Rules 13a-14(a) and 15d-14(a)
under the Securities Exchange Act of 1934, as Amended, and a Certification Pursuant
to 18 U.S.C. Section 1350 as Adopted Pursuant to Section 906 ofthe Sarbanes-Oxley
Act of 2002. Defendant Herbert also signed many ofthe Company's Forms S-K filed
with the SEC and made numerous public statements to the investing public through
various means including, but not limited to, press releases, media interviews and
con Terence calls with analysts and investors.
31. Defendant Herbert made numerous false and misleading
misrepresentations via SEC filings, press releases, and/or similar financial statements
and reports that were disseminated to the investing public. Among other things,
Herbert was responsible for NetBank's improper accounting practices in connection
with its non-conforming mortgage loans, as alleged more fully below. As CFE,
Herbert was responsible, acting under the supervision of defendant Freeman and the
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Audit Committee, for all financial accounting, financial reporting to investors and
regulators and financial statements of NctBank, as well as advising the Board of
Directors and senior management . Accordingly, Herbert possessed superior
knowledge ofand the power to influence and direct the financial accounting, financial
reporting, and financial statements at NetBank. Herbert provided substantial
assistance to, participated in, knew of, and/or recklessly disregarded the facts and
circumstances of the acts and transactions alleged herein.
32. Defendant Herbert joined NetBank in 2002 after the Company acquired
RBMG, where Herbert had served as the CFO prior to the acquisition. Herbert has
extensive experience in the accounting and financial services industry, having served
as the Chief Finance Executive ofRBMG for seven years. Prior to joining RBMG,
Herbert managed the 20-person audit practice of Price Waterhouse, LLP in Columbia,
South Carolina.. He also worked as Assistant Vice President, Manager of Bank
Accounting for South Carolina National Bank.
2. Douglas K. Freeman ("Freeman")
33. Defendant Freeman served as NetBank's CEO from April 1, 2002
through October 5, 2006. He became Chairman of its Board of Directors on January
29, 2003 and resigned that position on October 5, 2006. Like Herbert, Freemanjoined
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NetBank in 2002 after the Company acquired RBMG, where he served as the CEO.
Freeman signed the Company's Forms 10-K for the years 2004 and 2005. He also
signed a Certification Pursuant to Rules 13a-14(a) and 15d-14(a) under the Securities
Exchange Act of 1934, as Amended, and a Certification Pursuant to 18 U.S.C.
Section 1350 as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of2002
as to the Company's Forms 10-K for the years 2004 and 2005 and Forms 10-Q for the
first, second and third fiscal quarters of 2005 (filed with the SEC on May 10, August
9 and November 14, 2005, respectively) and Forms I0-Q for the first and second
fiscal quarters of 2006 (filed with the SEC on May 10 and August 8, 2006,
respectively). Defendant Freeman also made numerous public statements to the
investing public through various means including, but not limited to, press releases,
media interviews and conference calls with analysts and investors.
34. Defendant Freeman was responsible for the operations and management
of the Company and possessed the power and authority to control both the Board and
the officers and other executives of NetBank. Accordingly, Freeman possessed the
power to, and did in fact, direct the acts and transactions of the Company and the acts
of its officers and directors , including, but not limited to, the Company's accounting
practices and financial reporting. Defendant Freeman provided substantial assistance
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to, participated in, knew of, and/or recklessly disregarded the facts and circumstances
of the acts and transactions alleged herein. Freeman received a lump-sum payment
of $2.9 million as a severance package when he left NetBank in late 2006.
3. James P. Gross ("Gross")
35. Defendant Gross was appointed to replace Defendant Herbert as
NetBank's Chief Financial Executive ("CFE"), beginning in October 5, 2006, at
which time he was responsible for all financial operations and reporting for the
Company. At the time of his appointment as CFE of NetBank, Gross had served as
the Company's Controller since January 2004. From 2002 to 2004, he served as the
Company's Director of Financial Planning and Reporting . As CFE, Gross signed the
Company's Form 10-Q for the third quarter of 2006. He also signed a Certification
Pursuant to Rules 13a-14(a) and 15d-14(a) under the Securities Exchange Act of
1934, as Amended, and a Certification Pursuant to 18 U.S.C. Section 1350 as
Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 to the
Company's Form 10-Q for the third quarter of 2006. Defendant Gross also signed
many of the Company' s Forms 8 -K filed with the SEC and made numerous public
statements to the investing public through various means including, but not limited
to, press releases and conference calls with analysts and investors.
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36. As CFE of NetBank , Gross possessed the power to, and did in fact,
control and direct the acts and transactions of NetBank and the acts of NetBank's
officers as they related to the Company's application of accounting methods and
financial reporting of the operations of NetBank. Gross provided substantial
assistance to, participated in, knew of, and/or recklessly disregarded the facts and
circumstances of the acts and transactions regarding NetBank beginning as alleged
herein.
37. Prior to joining NetBank in March 2002, Gross served in this same
capacity at RBMG from 2000 through 2002. Prior to joining RBMG, he held
executive management positions with several mortgage banking companies, including
serving as CFO of IndyMac and J. L Kislak Group. Gross began his career in public
accounting with E&Y, which served as the independent auditors for RBMG and
NetBank.
4. Thomas H. Muller, Jr. ("Muller")
38. Defendant Muller was named Chairman ofNetBank on October 5, 2006,
replacing T. Steven Johnson. He served on the Company's Board and as Chairman
of its Audit Committee since its inception. Muller signed the Company's Forms 10-K
for the years 2004 and 2005.
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39. Defendant Muller has more than 30 years of experience in financial
management. lie is currently president ofMuller & Associates, a business operations
and financial management company. As the former CFO of SpectRx, Inc., he oversaw
that company's financial operations as well as personnel, administrative and legal
activities . His previous experience also includes serving as CFO for HBO &
Company and Coca-Cola USA.
5. Eula L. Adams ("Adams")
40. Defendant Adams served as a Director of NetBank during the period
from July 2003 until his resignation which was effective as of September 28, 2007.
As a Board member, Adams served as a member of the Audit Committee and
Corporate Governance Committee. In his capacity as a Director of NetBank, Adams
signed the Company's Forms 10-K for the years 2004 and 2005.
41. Defendant Adams is the Vice President, Data Management,
Group/Services Delivery, for Sun Microsystems, Inc. He has more than 30 years of
experience in financial services and accounting . Adams has also served as Vice
President, Global Services for StorageTekbefore its acquisition by Sun Microsystems
in August 2005. Previous to that, Adams spent 18 years with Deloitte & Touche
where he became a partner and served in various positions.
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6. David W. Johnson , Jr. "Johnson"
42. Defendant Johnson served as a Director ofNetBank from the Company's
inception in 1996, and also served as a member ofthe Board's Audit Committee until
his resignation from the Board in May 2005. In October 2006, Johnson was elevated
to Vice Chairman of the Company. Johnson signed the Company's Forms 10-K for
the years 2004 and 2005.
43. Defendant Johnson has more than 30 years of experience in mortgage
banking. Johnson served in various capacities with RBMG for eight years, including
chief operating officer, president, chief executive officer, vice chairman and
-managing director. Prior to joining RBMG, he was with Bear, Stearns & Co. Inc. and
with Bankers Mortgage Corporation.
7. Catherine A. Ghiglieri ("Ghiglieri")
44. Defendant Ghiglieri served as a Director of NetBank from December
2003 until she resigned on September 20, 2005. During that period, Ghiglieri served
as a member of the Board's Audit Committee. In her capacity as a Director of
NetBank, Ghiglieri signed the Company's Form 10-K for the years 2004.
45. Defendant Ghiglieri was the president of Ghiglieri & Company, a
management consulting firm she founded in 1999, after an extensive bank regulatory
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career. Ghiglieri served as Texas Banking Commissioner for seven years and was
responsible for the supervision of the third largest state banking system in the United
States. Prior to that, she spent 18 years in various positions of responsibility with the
Office of the Comptroller of the Currency.
46. Defendants Freeman, Gross, Herbert, Muller, Adams, Johnson, and
Ghiglieri are collectively referred to herein as the "Individual Defendants."
47. As a result of their positions with the Company, each of the individual
Defendants had access to the adverse non-public information about the Company's
true financial results, operations and condition, and each had access to internal, non-
public corporate documents, conversations and connections with other corporate
officers and employees, attendance at management and/or Board of Directors'
meetings and committees thereof, and reports and other information provided to them
in connection therewith. Because of their positions with the Company, all of the
Individual Defendants controlled and/or possessed the power and authority to control
the contents of the Company's SEC filings , press releases , and presentations to
securities analysts, through which information was conveyed to the analysts and then
to the investing public. Each of the Individual Defendants was responsible and
obligated to ensure the accuracy of the Company's SEC filings, reports, and press
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releases alleged herein to be misleading , and each had the ability and opportunity to
prevent their issuance if they were inaccurate or to promptly correct same.
48. Because oftheir positions and access to material non-public information
available to them, each of the Individual Defendants either knew or recklessly
disregarded that the Company's SEC filings, press releases, and presentations to
securities analysts contained material misstatements and omissions. Each of the
Individual Defendants is, therefore, liable formaking or participating in making such
material misstatements and omissions regarding the true state of the Company's
financial results, operations and condition.
49. Defendants Muller, Adams, Johnson, and Ghiglieri each served as
members of the Audit Committee of NetBank's Board of Directors at various times
during the Class Period.
50. The Charter ofthe Audit Committee of the NetBank Board of Directors
stated, in part, that:
The Audit Committee's purpose is to oversee the Company's accounting
and financial reporting processes and the audit of its financial
statements. The Committee shall provide assistance to the corporate
directors in fulfilling their responsibility to the shareholders, potential
shareholders, and investment community relating to corporate
accounting, reporting practices of the corporation, and the quality and
integrity of the financial reports of the corporation. In so doing, it is the
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responsibility of the Audit Committee to maintain free and open means
of communication between the directors, the independent auditors, theinternal auditors, and the financial management of the corporation. The
Audit Committee's performance and composition will at all times be
subject to, and in compliance with: (i) Section 1OA of the Securities
Exchange Act of 1934 and the rules promulgated thereunder; and (ii)
regulations promulgated by any stock exchange upon which the
Company's securities are traded.
51. The Individual Defendants are liable as direct participants in the wrongs
complained ofherein. In addition, the Individual Defendants, by reason oftheir status
as senior executive officers and/or directors, were "controlling persons" within the
meaning of §20(a) of the Exchange Act and had the power and influence to cause the
Company to engage in the unlawful conduct complained of herein. Because of their
positions of control, the Individual Defendants were able to and did, directly or
indirectly, control the conduct of NetBank's business and operations.
VI. OTHER RELEVANT PERSONS AND ENTITIES
A. Ernst & Youn LLP - NetBank' s Independent Auditor
52. Ernst & Young LLP ("E&Y") was, at all relevant times, the outside
accountant and auditor for NetBank. E&Y served as NetBank's independent public
accountants and auditors from 2002, having replaced Deloitte & Touche LLP as the
Company' s auditors . During the Class Period E&Y's NetBank engagement was
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headed by Engagement Partner Konstantin Grobovsky and Senior Auditor Nick.
Seina. E&Y continued to served as NetBank's outside accountant and auditor until.
its resignation on October 10, 2006, when it was eventually replaced by Porter Keadl e
Moore, LLP.
53. E&Y is a "Big 4" public accounting firm with offices throughout the
United States, including Atlanta, Georgia. E&Y was engaged to examine, audit, and
provide opinions on NetBank ' s financial statements for the years 2002, 2003, 2004
and 200 5. Specifically , E&Y audited NetBank's financial statements for, among
others, each of the fiscal years ended December 3 1, 2004 and 2005, issued
unqualified audit reports on those financial statements, and consented to the inclusion
of those unqualified audit reports in E&Y's Forms 10-K for those periods. E&Y's
unqualified audit reports on those financial statements were dated March It, 2005
and March 13, 2006, and addressed to the Board of Directors and Shareholders of
NetBank. However, those reports specifically provided that:
These financial statements are the responsibility of NetBank, Inc.'smanagement . Our responsibility is to express an opinion on thesefinancial statements based on our audits.
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B. Non-Party Directors of NetBank
1. J. Stephen Heard
54. J. Stephen Heard served as a Director of NetBank during the Class
Period. In his capacity as a director of NetBank, Heard signed the Company's Forms
10-K for the years 2004 and 2005. Heard is president of Heard Systems, Inc., a
provider of point-of-use systems and information systems consulting services. Ile
worked for IBM for approximately 30 years and later served as product sales
executive, Vanstar Corporation and area vice president, Hartford Computer Group.
2. Joel A. Smith, III
55. Joel A. Smith, IIi, served as a Director of NetBank during the Class
Period. In his capacity as a director of NetBank, Smith signed the Company's Forms
10-K for the years 2004 and 2005. Smith has over 30 years of experience in banking.
After retiring from Bank of America in 2000, he became Dean of the Moore School
of Business at the University of South Carolina. Smith joined Bank of America in
1971 and eventually served as the president of Bank of America East with
responsibilities for commercial, small business, premier and consumer banking
divisions.
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3. Robin C. Kelton
56. Robin C. Kelton served as a Director of NetBank during the Class
Period. In his capacity as a director ofNetBank, Kelton signed the Company's Forms
10-K for the years 2004 and 2005. Kelton is Chairman and Chief Executive Officer
of Kelton International Ltd., an investment banking firm formed in January 1.996
specializing in the banking and insurance industries. He is founder and former
Chairman and Chief Executive Officer of the Fox-Pitt, Kelton Group and Fox-Pitt,
Kelton, Inc. In addition, he is Chairman of Thomas Murray Limited, a financial
services company, Chairman ofFindlay Park Investment Management Ltd. and Eagle
& Dominion Asset Management Ltd., both fund management companies, and
executive Chairman ofFinancial Centre Corporation, the St. Lucia offshore financial
centre.
4. Stuart M. Cable
57. Stuart M. Cable served as a Director ofNetBank during the Class Period.
In his capacity as a director ofNetBank, Cable signed the Company's Forms 10-K for
the years 2004 and 2005. Cable is an attorney with Goodwin Procter LLP. He served
as a director of Resource Bancshares Mortgage Group, Inc. ("RBMG") from 1992
until its merger with NetBank on March 31, 2002, at which time he became a director
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of the Company.
5. Tamara L. Adler
58. Tamara L. Alder Lundgren served as a Director of NetBank throughout
the Class Period, beginning in December 2003. In her capacity as a director of
NetBank, Lundgren signed the Company's Forms 10-K for the years 2004 and 2005.
Adler is a senior finance professional and lawyer with more than 20 years of
structured finance, corporate and real estate experience. She also served as the
managing director and head of the Structured Finance group within Debt Capital
Markets at JP Morgan Chase. Prior to joining JP Morgan, she served as the managing
director and head of Deutsche Bank's European Securitization Group where she was
also a member of Deutsche Bank's Global Markets Management Committee. Adler
was also a partner at Hogan & Hartson, LLP in Washington, D.C.
6. T. Stephen Johnson
59. T. Stephen Johnson served as the Chairman of NetBank's Board from
the Company' s inception through early 2003 and, thereafter, continued to serve on
the Company's Board through the Class Period. In his capacity as a director of
NetBank, Johnson signed the Company's Forms 10-K for the years 2004 and 2005.
Johnson was President of Johnson & Associates ("TSJ&A"), a bank consulting firm
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located in Alpharetta, Georgia. The firm specialized in mergers, acquisitions and
regulatory consulting . TSJ&A has served as advisor and consultant in the formation
of approximately 70 banks in the southeastern United States. Mr. Johnson served in
a management capacity for two large Atlanta banks before forming TSJ&A in 1987.
Mr. Johnson also serves as Vice Chairman of Florida Banks, Inc., a bank holding
company, Chairman of Direct Payment Technologies, Inc., a card payment and
processing company, and Chairman of Brightlane.com, Inc., a business-to-business
portal. In addition, he is principal owner of Bank Assets Inc., a provider of benefit
programs for directors and officers ofbanks, and TSJ Advisory Group, an investment
advisory company.
VU. CLASS ACTION ALLEGATIONS
60. Plaintiff brings this action individually and as a class action pursuant to
Rule 23(a) and 23(b)(3) of the Federal Rules of Civil Procedure on behalf all persons
who, during the Class Period, March 16, 2005 through and including May 21, 2007,
purchased or otherwise acquired any securities publicly issued by NetBank, Inc.,
including without limitation NetBank common stock, and held such securities as of
May 21, 2007, and where damaged thereby (the "Class"). Excluded from the Class
are the Defendants herein, members of the Individual Defendants' immediate
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families, any entity in which any of the Defendants has or had a controlling interest,
any person or entity affiliated with any of the Defendants, and the legal
representatives, heirs, successors or assigns of any of the Defendants.
61. This action is properly maintainable as a class action because:
(a) The Class is so numerous that joinder of all members is
impracticable. According to the Company's Form 10-K for year ended 2005, as filed
with the SEC on March 15, 2006, NetBank had 46,586,415 shares of its common
stock issued and outstanding as of March 6, 2006. During the Class Period,
NetBank's common stock was listed and actively traded on the NASDAQ, a national
securities exchange and an efficient market, and a liquid market for NetBank common
stock. While the exact number of Class members is presently unknown and can only
be ascertained through appropriate discovery, Plaintiff believes that there are many
hundreds, possibly thousands, ofClass members located throughout the United States
who similarly purchased or otherwise acquired NetBank securities during the Class
Period.
(b) Plaintiff's claims are typical of the claims of the other members
ofthe Class. Plaintiff and the other members ofthe Class have sustained damages that
arise from, and were caused by, Defendants' wrongful acts alleged herein. Plaintiff
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does not have interests antagonistic to, or in conflict with, the other members of the
Class;
(c) Plaintiff is a representative party who will fairly and adequately
protect the interests of the other members of the Class and has retained counsel
competent and experienced in class action securities litigation;
(d) A class action is superior to other available methods for the fair
and efficient adjudication of the claims asserted herein, because joinder of all
members is impracticable. Furthermore, because the damages suffered by individual
Class members may be relatively small, the expense and burden of individual
litigation make it virtually impossible for Class members to individually redress the
wrongs done to them. The likelihood of individual Class members prosecuting
separate claims is remote;
(e) Plaintiff anticipates no unusual difficulties in the management of
this action as a class action; and
(f) Common questions of law and fact predominate over any
questions affecting any individual members of the Class.
62. Among the common questions of law and fact are:
(a) Whether the federal securities laws were violated by Defendants'
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acts and omissions as alleged herein;
(b) Whether the documents , press releases, financial reports and
statements disseminated by the Defendants to the investing public during the Class
Period misrepresented or omitted material facts about the financial results, operations
and condition of NetBank.;
(c) Whether NetBank's publicly disseminated financial statements
and reports were materially false and misleading as alleged herein;
(d) Whether Defendants acted with knowledge or with sufficient
reckless disregard for the truth in misrepresenting and/or omitting to state material
facts;
(e) Whether, during the Class Period, the market price of Net 3ank's
common stock was artificially inflated due to the omissions and/or material
misrepresentations complained of herein;
(t) Whether Defendants participated in and. pursued the common
course of conduct complained of herein;
(g) Whether the Individual Defendants were "control persons" within
the meaning of Section 20(a) of the Exchange Act; and
(h) Whether the members of the Class have sustained damages and,
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if so, what is the extent of such damages.
VIII. ADDITIONAL SUBSTANTIVE ALLEGATIONS
A. Corporate History of NetBank
63. NetBank was founded in October 1996 when it received its federal
banking charter. That same month, NetBank completed its initial public offering of
stock for $12 a share, under the name NetB@a nk Inc. At the time, the Company
claimed its operating expenses were half those of a traditional "bricks-and-mortar"
hank, and that it could thus offer customers higher rates on checking accounts and
certificates of deposit. When the Company began its Internet banking operations,
NetBank was one of the pioneers of the Internet banking industry, and its subsidiary,
NetBank., FSB, was recognized as one of the first successful internet-only banks. At
that time, NctBank's touted value proposition and product line was differentiated in
the marketplace, since few direct competitors existed. The Company claimed that its
products and services were designed to serve a growing base of computer-savvy
consumers who were seeking both convenience and greater economic value.
64. Over time, NetBank essentially evolved into a financial holding
company, but claimed it was still engaged primarily in retail banking. NetBank's
additional business segments grew to include mortgage banking, business finance,
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insurance and providing ATM and merchant processing services . See generally
Section IV, supra.
B. NetBank' s Business Segments
65. Prior to its demise in 2007, Netbank's business consisted primarily of
three segments: retail banking, transaction processing, and services as a financial
intermediary.
66. Retail Banking. Retail banking was NetBank's core business segment
from its inception . As the Company' s operations expanded into transaction
processing and financial intermediary services, NetBank insisted that retail banking
would remain its core business. NetBank's retail banking segment was comprised of
personal and small business banking operations, an automobile financing unit and a
business financing unit. NetBank, FSB, through its Internet banking operations,
operated as an Federal Deposit Insurance Corporation ("FDIC ") insured, federally
chartered thrift institution. NetBank, FSB offered a full line of deposit and loan
products, including checking and savings accounts, a small business banking
program, online bill payment, auto loans, and financial planning services. As such,
NetBank, FSB served approximately 285,669 customers throughout the United States
and in more than 90 foreign countries. NetBank, FSB delivered its products and
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services through remote delivery channels, such as the Internet, telephone and ATMs,
that were available 24 hours a day and seven days a week. NetBank, FSB did not
maintain a branch network to support its banking business. This branchless model
provided it with an opportunity to operate with less overhead expense than traditional
branch banks; however, it also presented numerous challenges not faced by traditional
branch based banks. Indeed, passing along part of the potential cost savings to
customers through higher deposit rates and better technology had been the
cornerstone of NetBank's supposed value proposition.
67. Transaction Processing . The transaction processing segment included
NetBank's ATM and merchant processing business, mortgage servicing division and
a number of start-up operations that delivered banking or item clearing functionality
to other financial institutions or merchants. NetBank established this segment in 2003
when it began restructuring the Company in attempting to leverage many ofthe core
business competencies in its retail banking and financial intermediary segments, and
market them on a business-to-business basis. Those action were supposed to provide
the Company with additional revenue generating opportunities from then existing
business activity. This shift in focus was motivated by the fact that NetBank's core
banking business was not as strong as it had been portrayed, and the viability of
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NetBank's business over the long-term was at particular risk if the Company did not
seek and obtain additional sources of revenue outside of its core banking business.
Through its transaction processing segment, NetBank had also been an active acquirer
of small, profitable processing businesses that, when properly executed, should have
supposedly complemented its overall business strategy. For example, in late 2003,
NetBank acquired an ATM and merchant transaction processing operation , including
the subsidiary known as FTY. During 2004 and 2005, the ATM and merchant
transaction processing operation grew through acquisitions and internal growth. At
its height, the business operated at least 9,649 ATMs across the United States. At the
time, NetBank ' s network ofATMs ranked as the second largest bank-operated ATM.
network in the country.
68. Financial Intermediary . The financial intermediary segment included
NetBank's mortgage and specialty lending operations. Through the segment's various
loan operations, NetBank served as an intermediary between consumers and
institutional investors. The Company diversified its operations through acquisition
to include the origination of loans for recreational vehicles (RVs), boats and personal
aircraft . The Company earned fees on the loans it originated and had the opportunity
to earn a profit on the sale ofthe mortgage loans or mortgage backed securities which
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consisted of portfolios of multiple loans packaged into an investment vehicle. The
loans were either retained by the retail banking segment to meet the Bank's
investment needs or sold to investors in the capital markets under the same
intermediary strategy the Company employed in its mortgage businesses. The bulk
of the business in this segment related to mortgage lending, and included both so-
called conforming and non-conforming products.
C. Overview of Bank Mortgage Lending
69. Mortgage loans fall into two broad categories: conforming and non-
conforming.
70. Conforming Mortgage Loans: Conforming mortgages are mortgages
that have terms and conditions that follow the guidelines and standards set forth by
the Federal National Mortgage Association ("Fannie Mae") and Federal Home Loan
Mortgage Corporation ("Freddie Mac"), two stockholder-owned corporations. Fannie
Mae and Freddie Mac guidelines establish the maximum loan amount, borrower
credit and income requirements, down payment, and suitable properties. Fannie Mae
and Freddie Mac announce new loan limits every year. Fannie Mae and Freddie Mac
also purchase mortgage loans that conform with. their guidelines from mortgage
lending institutions, such as NetBank. Once purchased, these conforming mortgages
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are then typically packaged into securities and sold to investors. Because these
"conforming" mortgages must comply with Fannie Mae and Freddie Mac guidelines,
they are understood to be safer investments that involve less risk than non-
conforming mortgages. Through this process, Fannie Mae and Freddie Mac, like the
Government National Mortgage Association ("Ginnie Mae"), provide a continuous
flow of affordable funds for home financing that results in the availability of
mortgage credit for American home buyers.
71. Non-Conforming Loans : A nonconforming mortgage is a loan that
fails to meet certain bank criteria for funding. Such a loan may fail to conform to the
bank's lending criteria because, for example, the loan amount is higher than the
conforming loan limit. A substantial portion of real-estate loans are qualified as non-
conforming because either the borrower's financial status or the property type does
not meet bank guidelines. Non-conforming loans can be either A-rated paper (less
risky) or subprirne loans (more risky). Subprime lending carries increased risk for
both lenders and borrowers due to the combination of high interest rates, poor
borrower credit history, and the questionable financial circumstances often associated
with subprime applicants. Due to the increased risk, subprime loans are offered at an
interest rate higher than A-paper loans.
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72. Mortgage originators "package" large volumes ofhome loans to be used
as collateral in massive mortgage-backed security ("MBS") offerings (also known as
collateralized debt obligations or CDOs) to investors such as ledge funds, allowing
the originators to further finance their activities.
73. During the course of the 1990s and early 2000s, as the housing market
in the United States increased substantially in strength, many lending institutions
were willing to provide mortgages to low credit high risk borrowers relying on the
increased value of the housing markets to provide protection against default. These
mortgages were then packaged for sale to investors.
74. In early 2006, as the housing market began to weaken, two trends in the
secondary market for subprime mortgages emerged: (1) sales of home equity loans
for borrowers with the weakest credit and the smallest cash down payments produced
sizable discounts as investors took into account the end of rapid home price
appreciation as a safety net for such borrowers, as well as other credit concerns;
however, lender pricing did not take these into account; and (2) forced repurchases
of subprime loans experiencing delinquencies early in their lives began to rise. Such
forced repurchases, reflect both a spike in "early payment defaults" and more
aggressive enforcement of related contractual clauses by the investors, especially
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Wall Street conduits.
IX. DEFENDANTS' ADDITIONAL FALSEAND MISLEADING STATEMENTS
A. NetBank's Surreptitious Transition From Its Core Banking
Operations to the Subprime Mortgage Market
75. From its founding in 1996 to 2001, NetBank had grown to become the
Country's largest retail Internet bank. During that period, NetBank went from
approximately 5,000 accounts with $100 million in deposits in 1996, to 245,000
accounts with $1,5 billion in deposits and $2.9 billion in assets as of December 31,
2001.
76. Beginning at least as early as 2000, NetBank faced two separate
problems. First, although new account growth allegedly remained robust, NetBank
knew that the base ofdepositors the Company relied upon to grow would soon mature
and, as a result, growth would then stagnate . Until that time, NetBank's business
model had been fueled solely by such rapid depositor growth in its core banking
sector. Second, NetBank knew that its new deposit accounts were substantially and
incrementally less profitable to NetBank than its mature accounts. Thus, even if
NetBank could continue to rapidly grow its base of depositors, doing so would prove
to be a significant drain on the bank's resources and severely hamper profitability --
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a fatal flaw to its basic growth strategy.
77. In an attempt to address these inherent problems with the Company's
business model, NetBank focused its efforts on two areas: (1) developing banking
products and services aimed at retaining customers, thereby fostering its more
profitable mature customer base, while seeking to actually slow the growth of new
accounts; and (2) shifting the Company's founding strategy away from its core
banking segment in order to develop other business segments that would leverage its
core banking assets. In making this shift, NetBank set about to begin acquiring one
or more mortgage companies.
78. On June 29, 2001, NetBank acquired Market Street Mortgage
Corporation ("Market Street"). Market Street was a retail mortgage lender based in
Clearwater, Florida, which primarily originated fixed first mortgages. In doing so,
NetBank made an initi al effort to concentrate on investing in singl e-fam ily residential
loans with adjustable rates to manage the interest rate risks. The past due rates on
these types of mortgages were approximately one-tenth the industry average which
fit the conservative strategy NetBank had pursued up until that time. The Market
Street acquisition enabled NetBank to originate over $3 billion in loans annually.
Market Street contributed positively to NetBank's earnings immediately following
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the first quarter after the acquisition, which appeared to validate the Company's new
strategy.
79. In the NetBank's 2001 Form 10-K, filed with the SEC on March 18,
2002, the Company reported the alleged success of its Market Street acquisition as
follows:
We also diversified and enhanced our income stream through the
acquisition ofMarket Street. This acquisition allowed us to generate fee
income related to the origination and sale of first mortgages, to reduce
the risk of material write-downs of premiums related to prepayment
activity during periods of declining rates, and to participate in the
increased refinancing activity during a period of declining rates.
80. However, in order for NetBank to generate the revenue sought, it was
necessary For the Company to significantly increase its mortgage-lending capabilities.
Buoyed by the apparent success o (the Market Street acquisition, NetBank continued
its expansion into the mortgage market through the 2002 acquisition of RBMG, a
wholesale mortgage banking company headquartered in Columbia, South Carolina.
RBMG had a nationwide network ofcorrespondents and brokers, and generated close
to $12 billion in mortgages annually. However, the RBMG acquisition included the
acquisition of RBMG's subsidiary known as Meri.tage , a subprime lender.
81. As alleged above, defendants Herbert and Freeman were, respectively,
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the CF() and CEO, of Meritage. As a result of NetBank's acquisition of RBMG,
Herbert became the CFF of NetBank and Freeman replaced D.R. Grimes as the
Company's CFO. Thereafter, under the direction and control of defendants Herbert
and Freeman and the Company's Board ofDirectors, NetBank surreptitiously shifted
focus from the primarily conservative conforming loans ofMarket Street and RBMG
to Meritage's highly risky subprime loans.
82. NetBank's 2002 acquisition of RBMG and, in particular, its Meritage
subsidiary , represented a crossroads for the Company's history because it ushered in
a new era for the Company during which NetBank was transformed from an Internet
based retail bank, to a financial intermediary to, ultimately, little more than a
mortgage bank with a significant presence in the subprime market.
83. Prior to the RBMG acquisition in 2001, NetBank had little, if any,
exposure to the non-conforming mortgage market. In its 2001 Annual Report,
NetBank claimed that the RBMG acquisition "dramatically expands the company's
lending ability." In the same Report, NetBank went on to state:
NetBank's efficient deposit gathering will provide Market Street
Mortgage and RBMG a lower cost source of funds for loans. With the
acquisition of RBMG and Market Street Mortgage, NetBank will
produce more earning assets than core deposits. We will sell the
majority of our loans into the secondary market, and these assets will
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remain on our balance sheet only for the amount of time that it takes tosell them.
84. Despite N"etBank.'s continuing evolution from an Internet based bank to
a subprime mortgage company, the Defendants attempted to deceive the investing
public into believing that it was not a significant subprime lender. For example, on
August 3, 2005, defendants Herbert and Freeman engaged in the following colloquy
with an analyst (emphasis added):
ANNETTE FRANKIE, ANALYST, FRIEDMAN BILLINGS
RAMSEY: *' ** And also, I wanted to ask on the sub-prime
originations , how deep do you go into the cycle spectrum on the sub-
prime loans?
STEVE HERBERT: Okay. Well, on the sales versus production side,
there is nothing unusual there. The volume of production did exceed
sales, so we created more value and it was released into the income
statement in the current quarter. That is just normal timing in periods in
which volumes tend to accelerate, sales tend to lag because of the 30-
day delay on sales. If you looked at production for April-or March,
April, and May, generally I think you'd find that probably lines up fairly
well with the level of sales that we did in the second quarter because
there's basically a 30-day warehouse lag built into the process. Nothing
peculiar going on. Our sub-prime originations, I have to get you the
distribution of our FICO scores. It is fairly tight.
We do not do anything that you would call C and D type lending. Ingeneral, it's a fairly tight distribution of FICO scores, right around the640-average level. We do have some very high FICO scores in there iswell for some customers that just do not want to do all the paperworkand want to buy big house that does not meet Freddie or Fannie
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guidelines. But I think you are going to find a tight cycle band around
64() that we will be able to show you.
DOUG FREEMAN: Annette, this is Doug. We really don't look like a
subprin,te lender. We call it non-conformingfor° a good reason, that we
look a lot closure [sic l to a confirming loan than we look to some afthe
sections lenders out there.
1. Operational Shortcomings
85. In order to decrease the risk of default relating to subprirne non-
conforming mortgages (as well as, in fact, conforming mortgages), it is critical that
the lender institute a strong set of internal controls to accurately assess the credit
worthiness of each borrower . This is critically important as defendant Freeman
admitted to the Atlanta Journal and Constitution on July 27, 2006, during the Class
Period, because even if non-conforming loans are not bad, "investors who buy the
loans will sell them back if any discrepancy or misrepresentation [by the borrower]
is later found in documents associated with those loans."
86. Indeed, NetBank claimed to have just such a set of strong internal
controls to reduce the risk inherent for its own "non-conforming" loan business. For
example, in its Annual Report for the year 2000, NetBank claimed:
The discipline NetBank has in managing assets is second to none. Webring a scientific and mathematical approach to our process. Everything
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is quantified, including all aspects of loan and customer performance, aswell as pricing and risk implications. We have developed best-executionmodels to enable us to optimize our delivery into the secondary markets.
In each phase of this cycle, we rely on rigorous analytics to determine
the optimal conditions for selling a loan so that we can manage our risk
appropriately while obtaining the highest value possible for our
shareholders.
87. Thereafter, and throughout the Class Period, Defendants continued to
claim that NetBank maintained strong internal controls to reduce the risk associated
with its loan business. For example, in the Company's Form 10-K for the year ended
2005, Defendants stated:
We have a quality control program to monitor compliance with our
established lending and servicing policies and procedures, as well as
with applicable laws and regulatory guidelines. We believe that the
implementation and enforcement of our comprehensive underwriting
criteria and quality control program are significant elements in our
efforts to purchase high-quality mortgage loans and servicing rights. Our
quality control department examines loans in order to evaluate the loan
purchasing function for compliance with underwriting criteria. The
quality control department also reviews loan applications for compliance
with federal and state lending standards, which may involve re-verifying
employment and bank information and obtaining separate credit reports
and property appraisals.
88. Ultimately, such assurances were exposed to be false. Indeed, in closing
down NetBank's operations on September 28, 2007, the federal Office of Thrift
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Supervision issued a press release that specifically attributed NetBank's demise in
part to "weak underwriting", "poor documentation" and "a lack of proper controls".
89. In addition , NetBank 's "branchless" bank model, while innovative, was
not without its limitations. One of the most significant disadvantages facing
depositors of on-line only banks such as NetBank revolves around physical deposits
and withdrawals and ATMs. Since, initially, NetBank had no ATM machines and
never had branches, customers had to rely upon the United States Postal Service to
deposit checks and had no means to deposit hard currency. Similarly, account holders
could not cash checks or withdraw cash at branches. Rather, in order for a NetBank
account holder to obtain their funds in cash, they were required to use an Automatic
Teller Machine ("ATM"). However, because initially NetBank did not own or operate
a network of ATMs, NetBank account holders were forced to use ATMs operated by
competing banks and, in most cases , to pay a fee to do so. Additional downsides
included deposits that could be lost, damaged or delayed in the mail and could not be
tracked without the sender purchasing expensive mail tracking services.
90. The invention of deposit-taking ATMs coupled with NetBank's
acquisition of a large network of ATMs alleviated some of the limitations of
NetBank's actual and prospective account holders because they could make deposits
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in a local ATM, where their check would post and clear very quickly. However, the
widespread nature ofNetBank's customers made it difficult to have ATMs that were
convenient for all customers and many were still required to use mail-in deposits.
91. NetBank attempted to alleviate the cumbersome and potentially risky
issue of making physical deposits by creating QuickPost, a service whereby a
customer drops a deposit off at a UPS Store location to be shipped overnight to
NetBank. The concept underlying QuickPost was that one shipment could contain
deposits from several customers, justifying the additional expense of overnight
shipping. However, the product did not take off, and NetBank was forced to shut
down this operation in 2006.
92. NetBank heralded the development of QuickPost in its Annual Report
for the year 2004, fled with the SEC March 16, 2005 , stating:
For consumers, small business owners and institutions that use
NetBank's transaction processing services, our goal is to offer the most
needed products and services in the most convenient and versatile
setting. To deliver these effectively, we implemented a new online
platform and opened a state-of-the-art payment processing center that
positioned NetBank to take immediate advantage of legislation
authorizing the use of electronic check images. The new processing
center also made it possible for NetBank to develop QuickPostSM, a
service that allows customers to drop off deposits and payments at
approximately 3,800 locations of The UPS Store® for overnight
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delivery and next-day processing.
QuickPost is a service designed to dramatically reduce the time from
check drop-off to availability of funds. Through our agreement with
UPS, a customer can take a deposit or mortgage payment to one of
approximately 3,800 The UPS Store® locations for free overnight
shipment to our payment processing center. Customers receive an e-mail
acknowledgment when the deposit is received the following business
day. This service provides customers greater convenience, security and
quicker access to funds.
Initially piloted in Atlanta, Chicago, New York, Oakland and San
Francisco, QuickPost is now available to all. NetBank customers.
QuickPost represents one more way NetBank is branching out with
innovative services.
93. According to a confidential witness, who was a NetBank officer
employed in the Corporate Finance Department throughout the Class Period and who
had direct dealings with top management including CFE Herbert, NetBank was aware
that QuickPost was an -unsustainable initiative . After implementing QuickPost,
NetBank determined that there were an average of 1.2 deposit items in each envelope
they received, and the cost to NetBank for each envelope sent in was between $11.00
and $1.5.00. Therefore, the cost of QuickPost to NetBank far exceeded the
incremental value of the deposits and further eroded the limited profits that the
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Company earned from depositors while creating an expectation on their part that
NetBank could not readily eliminate without risking further erosion of its depositor
base.
94. During NetBank's August 3, 2005 conference call with analysts and
investors, relating to the second quarter of 2005, the Defendants repeatedly touted
Quick Post:
We are actively promoting an array of services to other financialinstitutions, chiefamong them being Quick Post, our deposit-forwardingservices through the UPS stores. A lot of interest has been expressed inthis service. Our own Net Bank customers have adopted it in droves.During the second quarter, more than a third ofour paper check depositscame in through it.
MATTHEW SHEPHERD : Let me hit the UPS. And I'll let Steve talkabout the seasonality and some entries on the servicing side that I thinkgot us above $ 100 million , probably in the fourth quarter i f I'm notmistaken . Ifyou look at the UPS stuff, Rich , we are extremely bullish onthat . Our customers have already used 90% of the UPS stores to sendpaper checks in to our image Check 21 factory . And the system isworking unbelievably well . Our customer feedback has been outstandingin the process . As we've said publicly, we are very close to announcingother people who have the same transportation-- paper transportationcustomer service funds distribution issues that we are , that they arenational institutions that lack national bricks and mortar. So they'reforced to use our good of postal service or whatever to get theirpayments and checks in to their company. And they have a great interestin coming on the system . So what you will see is, at some point, whenwe have added a third party to our mix, we will break Quick Post out in
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our numbers and that to you and show you metrics that will be able to
get you there. I cannot tell you, Rich, what quarter that will be, because
it needs to be material when we break it out. But I feel extremely good
that you're going to see some very attractive announcements that are
going to move us in that direction.
MARK SPROULE: Just to shift gears-- thank you for the questions-- on
the banking side, you'd mentioned, I think in an earlier question, your
continued focus and ability to drive double-digit asset growth and then
continue small-business customers. flow are you going about right now
attracting those, I mean because we see it on the monthly statistics, you
are not seeing significant ramp up monthly as you go, ofnew customers
there. Are you using rates as your driving force? Or is the QuickPost,
PowerPost type appeal really the method to act the new customers in
and what kind of attraction you are getting? Thanks.
DOUG FREEMAN: The market today, because of our company, we
don't have the earning assets that allow us to be purely a rate play. And
as a matter of fact, that's never been in our strategy. If somebody wants
the hot money, hot, hot, hot money, money market only type of things,
they can probably get a better rate from someone who has got some sort
of match-to-earning asset that they can deploy that against. And today,
we do not have that. So we are extremely competitive from a rate
perspective. But we focus on value. So, if you're a retail customer, it's
the quality of our technology, it's things like QuickPost and all of that
if you're a small business. It's a plethora of services that we offer from
convenience to actually on the phone business bankers to work with
these people. We have online payroll, we have QuickPost, we have
PowerPost and it could go on and on and on. So our strategy has always
been to be a super regional bank in terms of how we approach the
business, but our region is the Internet. If that make sense to you.
95. In its Form 10-Q for the period ending September 30, 2005, NetBank
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reported that, "Expenses increased primarily as the result of increase in marketing
costs related to specific promotions and on-line advertising campaigns that occurred
during the third quarter of 2005, expansion ofDealer Financial Services' operations,
and the roll-out in 2005 of QuickPost, which provides a more convenient way for
customers to make deposits to their NetBank accounts."
96. During NetBank's conference call with investors for the period relating
to the third quarter of 2005, Quick Post was repeatedly touted despite its continuing
drag on earnings because, although many customers had utilized the service, it was
costing NetBank more money to make the service available than the retained
customers were generating for the bank:
The feedback we continue to receive from our own customers aboutQuick Post is overwhelmingly positive. They see it as a very convenient,highly secure method of making deposits and payments.
We continue to view Quick Post as one of the keys to our transactionprocessing revenue growth. USAA and other partners have the potentialto generate significant fee income for us, over time, if their customersadopt this channel to the extent that ours have. Steve will give you moredetail on the various points in his review ofour performance by businessline in a minute.
As a whole, today our company's fundamentals are strong. We have asolid capital position with an attractive base of customer deposit
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relationships. We also benefit from our varied lending operations and
the high potential transaction process and initiatives we have underway.
The work we're doing on that front with Quick Post and Power Post
continue to show great promise. Through relentless execution of our
game plan, we will continue to provide superior service to our chosen
customer segments and prove the company's core earnings profile and,
most importantly, create better value for our shareholders.
JENNIFER DEMBA: Doug, can you give us some sense of what the
penetration and the usage is like for the Quick Post right now from your
customer base?
DOUG FREEMAN: About 90% of the UPS stores are now in the
business ofaccepting loan payments or deposits and forwarding them to
us. So that's unbelievable penetration on the UPS store side. If you look
at our customers, what you see is that if you take out direct deposit of
payroll, about 30% ofthe deposits that we get today are coming through
Quick Post, and we expect that number, actually, to go up, over time, as
we continue our marketing efforts.
97. In its 2005 Form 1.0-K, NetBank reported that "[n]on-interest expense
also increased due to the implementation of the QuickPost initiative as well as
increases in software maintenance expense ." The Company also reported that
"improvements in earnings were offset, in part, by increases in operating expenses of
some $8.735 million, primarily relating to the growth in our auto lending and leasing
operations, as well as the introduction of our QuickPost initiative."
98. In its Form 10-Q for the period ending March 31, 2006, NetBank
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reported that "operating expenses increased by $2.594 million primarily due to
increases in expenses related to our QuickPost initiative."
99. During NetBank's conference call with investors for the period relating
to the forth quarter of 2005, Quick Post was repeatedly touted:
A - Steven Herbert
And second thing you asked about, quick post, quick post continues togo very well....
A - Steven Herbert
So ifyou remember what our model is, we have the super regional bank
model, which is full service financial institution with the exception and
our region is the internet, which has to say that we offer the second
largest bank, ATM network to our customers, we offer quick post which
actually gives them better, convenience for making deposits or
payments, and better funds availability, than most of the large banks, so
we don't intend to be a product player, we intend to be a distribution can
do it player, which says to me that full service financial institution,
delivered over the internet to a highly targeted group of customers.
Q - Mark Sproule
Got you, and then with the transaction servicing side I mean how do you
look at building that out of - is the return on building the kind of ATM
network cost effective or is it more beneficial to your branding effort
especially given sort of quick post build outs etc?
A - Steven Herbert
Well its, taste great analystfilling, it is absolutely a cornerstone ofourubiquitous convenience value proposition to our bank customers and
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secondarily the way we run the ATM business to remind you we ownless than 5% of the ATMs so its not capital dependent on us to be ableto do this. So it's a situation where at large mega bank as it cost downso much per year to provide ATM access to the customers, in my caseT make so much year by providing ATM access to my customers, sowhen your $5 billion bank you have to be smarter than the average bearand we re-engineered the ATM business value proposition from anoutflow to an inflow. We would expect Quick Post to overtime be thesame thing, we now have unprecedented convenience to our customerswho need a place to make a deposit or make a payment, we granted thatquick post so we could sell that to other banks customers like USAA andothers who will come into that system we believe overtime and create aproposition again when we provide unprecedented ubiquitousconvenience to our customers and make money on that channel at thesame time.
100. During NetBank's conference call with investors for the period relating
to the first quarter of 2006, the Defendants continued to tout the prospects for Quick
Post despite their knowledge that the initiative was failing:
Our main areas of focus in the coming months will be three fold...andnumber three, move quick post towards profitability by leveragingcurrent partnerships and pursuing new ones.
^^xx
A - Steven Herbert
That's correct, Mike. The Retail Bank did show some loss, whileNetBank Business Finance had a better quarter on somewhat highervolumes, really drove that, and somewhat reduced the moderatingprovision loans for the bank standing alone. Retail Bank standing alonereported a $1.4 million loss. A good bit ofthat or actually the vastmajority of that relates to, at least in part, to the investment that we
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continue to make in the QuickPost product.
A - Douglas Freeman
And the issue in here will be QuickPost and PowerPost, and those arcthe strategic initiatives as we move forward managing through that.
101. During NetBank's conference call with investors for the period relating
to the second quarter of 2006, the Defendants stated:
As we explained in the press release, the primary driver to QuickPost
expenses is the number of UPS stores sending packages in each day.
About two-thirds of the stores are now generating packages on a daily
basis. The cost for these packages remains the same, whether there is
one deposit in a package or 20. The key is now to increase the number
of deposits or payments contained in the packages.
The headline really inside the retail bank is the QuickPost, PowerPost
and NetServe expenses which we pulled out to enhance people's ability
to sort of see the numbers, or this additional detail, I think, adds some
color to what's really going on there. That operation has a heavy initial
marginal fixed cost structure, so those marginal fixed costs are
frontloaded as volumes come on board. So we've seen a significant
uptick in the expense structure, and that's what accounts for the increase
that we've seen in the next expense from QuickPost, PowerPost and
NetServe as we continue to make an investment in those initiatives.
The retail bank, excluding the Quick-Post, PowerPost and NetServe
initiatives posted about a $1.6 mill ion operating profit after taking out
the HELOC gain on sale and overall, obviously, we got leverage long-
tenn and a flat yield curve that's going to probably slowly grind against
those numbers or work against improving it, so we're slightly negative
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on the outcome that we would probably see there after adjusting.
QuickPost, PowerPost, NetServe, most of the fixed costs are probably
in the numbers that you're looking at in the current quarter. They
probably will get a little bit worse before it gets better. We are, I guess,
optimistic that it won't get too much worse before wve get to the volume
levels that will start to result and it'll move back towards breakeven or
profitability for those investments.
Q- Hi, guys. Yes. Daniel Hayes in for Mark Sproule. Is there any way
for you to quantify the benefit of the QuickPost contribution - sorry if
you've already mentioned this -- to earrings growth, to the earnings
asset growth, and maybe quantify more of the expenses surrounding
QuickPost?
A - Doug Freeman
Yeah, I think - this is Doug, Daniel. We have started to breakout the
expense stream so that you all can start getting a handle on the expenses
associated with it. Secondarily, a couple of months ago we began to
break out QuickPost volume back 12 months historically. So with that
being said, at some point in time you all are going to be able to get your
hands around the marginal costs, marginal revenue associated with that.
But as of today, the only metrics that we give you are the total expenses
and then the volume.
M. During NetBank's conference call with investors for the period relating
to the third quarter of 2006, Defendants stated:
We have made the hard decision that we had to make with respect toQuickPost and FTI and we are in process of exiting that business andexpect it to be completed by the end of the year, check it off the list.
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In the second quarter, the retail bank earned $1.8 million, ifyou excludethe QuickPost expenses and take out the gain on sales of HFLOC.
103. During NetBank's conference call with investors for the period relating
to the third quarter of 2006, NetBank reported that "we were still in our QuickPost
operation losing S3 million a quarter , trying to prepare for a future far off into the
distance."
2. Failed ATM network and Check Clearing Business
104. According to a confidential witness, who was a senior executive officer
of NetBank during most of the Class Period, and who had direct daily contact with
the top executive officers, the Company's network of ATMs was an integral part of
NetBank's Internet banking model, but never gained acceptance with customers.
Despite Defendants ' knowledge that NetBank 's ATM network and related Check
Clearing business were failing, the Company continued to allocate capital to them
because in the face of mounting subprime losses NetBank could ill afford to risk
eroding its depositor base if it abandoned its ATM network.
105. According to a confidential witness, who was a senior corporate officer
of NetBank during most of the Class Period, and who provided input directly to
defendants Freeman, Herbert, and Gross, the ATM business purchased by NetBank
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was the 2" largest network in the U.S. However, the Defendants knew that the
network of ATMs was located in non-strategic locations that made it ineffective for
the purpose of generating sufficient acceptance and use by NetBank's depositor
customers.
106. According to a confidential witness, who was a senior executive of
NetBank during the entire Class Period, and who had regular daily interaction with
defendants Freeman, Herbert and Gross, the Defendants knew that Quick Post and
NetBank's ATMs were flawed initiatives.
3. Warehouse Line of Credit
107. NetBank and Meritage maintained a warehouse line of credit which was
essential to the continued operation of the Company' s mortgage business . Meritage
used and relied upon that line of credit to make subprime loans and could not have
generated the level ofsubprime mortgage loans that it did during the Class Period had
it not been for Meritage's reliance upon the line of credit.
108. A warehouse line of credit ("WH") is a revolving debt facility or line
of credit in which a mortgage banker, such as Meritage, arranges for a loan from a
warehouse lender. The original note from the loan is then kept by the warehouse
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lender while the remainder of the documents go to the mortgage banker, who then
offers it for sale. When an investor purchases the loan, the warehouse lender gives the
original note to the investor. The purchase price is given to the warehouse lender to
pay for the advances and fees. The mortgage banker then keeps the remainder of the
proceeds from the sale. This cycle starts over on the next loan.
109. WHLs are typically used by mortgage bankers, such as Meritage, for a
variety of reasons including: (1) the control of funds by the mortgage banker, since
it has more control over the process of drawing loan documents; (2) permanent
funding, since typically unless the loans fail to comply with agreed upon criteria, the
lender is not obligated to buy back loans-the line of credit provides permanent
funding for the life of all loans in this program; (3) reduced risk, since once the asset
is funded, there is no additional mark-to-market and. posting of collateral and no
margin calls ; (4) unlimited loan volume, whether on or offbalance sheet , since WHL
programs can potentially fund an unlimited loan volume which enables specialty
lenders to enlarge their portfolios for maximum interest income and eliminate the
need to manage multiple sources of capital.
110. According to a confidential witness, who was a senior executive of
NetBank during the entire Class Period, and who had regular daily interaction with
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defendants Freeman, Herbert and Gross, E&Y's continued refusal certify NetBank's
prior financials after E&Y resigned led to NetBank's loss of its WHL, which was a
contributing factor to the demise of NetBank. As the Defendants were aware, ifE&Y
refused to certify NetBank's financials, making it impossible for NetBank to file
financial statements with the SEC, the Company's stock would be delisted which, in
turn , would cause the Company to lose its WHL. As alleged, the maintenance of its
WHL was essential to the continuation of operations at Meritage.
4. Mortgage Underwriting by Meritage
111. Underwriting . Meritage was comprised oftwo separate regional centers.
The Jacksonville, Florida center's function was to bring in new subprime mortgages;
the center in Oregon. was to package the mortgages into portfolios and then sell those
portfolios of loans to investors.
112. Meritage relied upon independent mortgage brokers to generate the sub-
prime mortgages that it packaged into portfolios for sale. According to a confidential
witness, who was senior managerial executive of Meritage during most of the Class
Period, as a result of the manner in which Meritage generated its subprime loans, the
Company had little control over the quality of the loans available to it for purchase.
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As a result, in order to reduce the risk of purchasing low quality loans that carried a
high risk of early default, it was necessary for Meritage to adopt stringent standards
of review and to develop strong long-term relationships with reliable brokers.
However, according to that confidential witness, in most instances, the brokers
bringing loans to Meritagc were "one-time broker[s]" for Meritage while others might
bring Meritage only a few loans and none of the brokers were "regulars" that had an
ongoing relationship with Meritage.
113. The types of subprime mortgages that Meritage sought were largely
dictated by the criteria that investors, the ultimate purchasers, wished to purchase. In
the Oregon segment of Meritage, Rick Baldwin was the individual in charge of the
secondary marketing for Meritage. As such, Baldwin worked with the investors who
ultimately purchased the portfolios of Meritage subprirne loans. According to a
confidential witness, who was senior managerial executive of Meritage during most
of the Class Period, the underwriting guidelines used by Baldwin and Meritage were
not uniform. Rather, Baldwin and Meritage utilized unique underwriting guidelines
for each investor. Individual agreements were then reached with each investor which
contained the responsibilities of the investor and Meritage including the terms under
which loans could be "put back" to Meritage. To address the attendant complexity,
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all of the various underwriting guidelines were combined into a single homogeneous
set of underwriting guidelines to be used by the Jacksonville branch when they
brought in the loans from mortgage brokers. According to this confidential witness,
the true purpose of the homogenous underwriting guidelines was to answer the
question "at the end of the day, wi 11 the investor buy the portfolio?" In sum, according
the confidential witness, ifthe answer to that question was "yes," then the loan would
be funded, if the answer was "no" the loan would not be funded.
114. As alleged, even where a loan meets the investor's underwriting
guidelines, such loans can nevertheless be "put back." Put backs were also referred
to as "buy backs" and "kickouts." During 2004 and 2005, loans from the portfolios
that Meritage had sold to investors began to be "put back" in ever increasing
numbers. Typically, a loan that met the investor's underwriting guidelines could be
put back if it fell into one of two categories: Early Payment Defaults (EPD) or First
Payment Defaults (FPD). EPD meant that the borrower defaulted or was delinquent
in the first 90-180 days of the loan. FPD meant that the borrower defaulted or was
delinquent on the loan's first payment.
115. According to a confidential witness who was a high-level manager in
NetBank's Finance Department during the entire Class Period and who reported to
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defendant Herbert and, later defendant Gross, among others, by as early as May 2006,
Herbert embarked on a plan to reduce the numbers of subprime loans on NetBank's
books by selling them to other financial institutions. Although defendant Herbert
continued to reassure the investing public on this point, his goal was to get NetBank
entirely out of the subprime lending market. When NetBank sold these loans, they
contained a provision of the sale that enabled the purchaser to put these loans back
to NetBank in the event of Early Payment Default (EPD) or because the loans were
defective for any reason.
116. By 2006, NetBank and its senior officers learned that the investors who
purchased its Meritage subprime loan portfolios had hired due diligence companies
to look for reasons to put back loans to Meritage even where they met the investors
guidelines.
117. In mid-2006, senior managers of Meritage and the Office of Thrift
Supervision, over a three weekperiod, examined Meritage's internal controls. Among
the findings was that Meritage had no process for revealing when the terms o f a loan
were changed in the middle of the teen of the loan which could lead to significant
losses to the company.
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118. Volume. By March 2005, during a monthly, internal .M.eri.tage
conference call, one item of discussion was the fact that certain market conditions,
such as the so-called two-year swap, was working against Meritage, thereby reducing
its already thin profits. According to a confidential witness who, during most of the
Class Period, was a senior managerial executive of Meritage, Russell Burdsall, who
was the NetBank Head of Mortgage Operations, acknowledged that NetBank's
mortgage profits were "razor-thin"; nevertheless, Burdsall directed Meritage
executives to "push the volume" ofthe subprime loans. According to that confidential
witness, Rick Baldwin, the then-Director of Capital Markets at Meritage Mortgage,
stated on a May 2005 conference call that although. investors were still buying the
Meritage portfolios, the profits had been reduced. For example, originally, Meri.tage
had received 106 basis points per loan, which dropped to 101 basis points per loan
at that time. As a result, by early 2005, although Meritage continued to produce loans,
it either lost money doing so or generated only minimal profit.
119. Rather than reveal the nature of the problems at Meritage, Defendants
embarked upon a strategy that de-emphasized risk controls and emphasized volume.
This strategy, while a potentially short term fix - aimed at increasing Meritage's
"razor thin profits" by volume rather than through quality - also increased the risk to
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Meritage and NetBank.
120. A former high-level manager in NetBank's finance department during
the entire Class Period who reported to Herbert and, later Gross, among others, was
astonished at how low Meritage had allowed the quality of loans and underwriting to
become, even providing subprime home loans to people who had gone bankrupt.
121. In addition to NetBank's increasingly lax underwriting standards, the
Company's increasing reliance on volume led it to accept and, ultimately, conceal.
losses on put backs that it was not required to accept. For example, in one incident,
Charles Mapson, NetBank's Chief Legal Officer, reviewed certain loans that an
investors wished to put back to the Company. Although Mapson is understood to
have determined that the loans actually met the guidelines and were put back long
after the 30 day guideline limit, he approved NetBank's repurchase of the loans to
ensure a continuing relationship with the investor which was essential to the
generation of an ever increasing volume of loans to support NetBank's razor thin
margins.
122. As set forth in the above section and as alleged elsewhere herein,
Defendants' made material misrepresentations and omissions regarding NetBank's
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transition as a subprime lender. As such, Defendants failed to properly disclose that
the nature of NetBank's core banking business was deficient, and that the focus of
NetBank's mortgage lending business had shifted from conservative, conforming
mortgages to making a late entry into subprime lending and other risky lending
practices.
123. OTG Audit Report. The above omissions have now been confirmed in
an Audit Report by the Office of Inspector General, Department of the Treasury,
dated April 23, 2008, titled "SAFETY AND SOUNDNESS: Material Loss Review
of NetBank, FSB" (the OIG Audit Report"). That Report presents, among other
things, the results of the OIG's review of the failure ofNetBank, FSB -- a failure that
the FDIC estimates will cost the Deposit Insurance Fund some $108 million.
Specifically, the OIG Audit Report found that large losses related to NetBank's
mortgage banking operations and commercial lease portfolio were among the
significant causes ofNetBank's failure. The OIG Audit Report cited that not only did
NetBank's mortgage lending practices contribute to its demise but also the fact that
the Company did not have a viable core banking business as it constantly touted:
While its mortgage banking operations did contribute substantially to
NetBank's earnings, by mid 2005 these earnings began to contract. At
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the same time, the secondary mortgage market was experiencing adramatic downturn. Rather than curtail its mortgage banking operationswhen faced with this deteriorating earnings scenario, NetBank insteadattempted to increase loan production by lowering its underwriting anddocumentation standards. Not surprisingly, this led to poor loan quality.NetBank sold these loans on the secondary mortgage market withrecourse provisions to investors. Recourse provisions out] me the termswhen the investor can request the thrift to buy back the loans.Ultimately, in 2006, NetBank had to make good on many of thoseprovisions and repurchase $182 million in loans. Ultimately, whenNetBank's mortgage operations became unprofitable, it did not have aprofitable core business to fall back on.
124. The OIG Audit Report provides a chronology of NetBank ' s entry into
the subprime lending market and the Company's subsequent collapse, which appears
to confirm Plaintiffs historical recitation set forth above, reporting in pertinent part:
NetBank responded to declining gains on the sale of loans by attemptingto maintain high loan volumes at the expense of the quality of loanoriginations. This resulted in an increase in repurchase requests from thebuyers of the sold loans. The thrift repurchased $1S2 million ofmortgage loans in 2006 and recorded related loss provisions totaling
$78.1 million.
Beginning with the first quarter of 2006, NetBank began reportingincreasing levels of quarterly losses. 'The thrift reported a pre-tax netloss of $203.6 million in 2006, with $80 million of that loss incurred inthe fourth quarter. NetBank's other business lines were not sufficientlyprofitable to offset the mortgage banking losses and, in some cases,contributed to the reported loss. In October 2006, NetBank's chairman
of the board/CEO resigned.
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In the latter half of 2006, NetBank management pursued several
strategies to counter its losses, including selling several business lines
and some loan portfolios and terminating the subprime mortgage
banking operation. These strategies were not successful, as evidenced
by the losses in 2006 which continued in 2007. An agreement to sell
almost the entire thrift was entered into with EverBank. Financial
Corporation in May 2007. As NetBank sold off or exited business lines
in preparation for the sale, its losses continued, totaling $120.2 million
for the second quarter of 2007. The sale to EverBank Financial
Corporation was not consummated because NetBank did not have
sufficient cash and saleable assets to close the transaction under the
terms of the agreement. With no viable plan for the thrift to restore
capital and achieve profitability, OTS exercised its authority to close the
institution and appointed FDIC as receiver on September 28, 2007.
125. Moreover, the O1G Audit Report confirmed that NetBank not only
surreptiously shifted its mortgage lending into the risky subprime market, but that
NetBank's claims of diversification were bogus, as the Company did not even have
a viable core banking segment:
Lack of Consistent Core Earnings
NetBank never established a consistent profitable core business ....
NetBank offered relatively high interest rates on deposit accounts and
covered these deposit costs by investing in a mix ofloan portfolios with
higher yields and credit risk. Rather than incurring loan origination
costs, NetBank paid premiums to acquire loan portfolios necessary to
achieve the asset mix it desired. The savings from not maintaining an
in-house loan origination function did not prove adequate to compensate
for the premiums paid for loans that the thrift purchased.
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The net yield on the thrift's loan portfolios did not cover deposit costsand G&A. expenses to the extent necessary to produce core earningsperformance at the peer group median level. As a result, as discussedabove, NetBank. acquired Market Street and RBMG and became entirelydependent on mortgage operation income for profitability. The initialprofitability of this segment masked underlying weaknesses, includingunusually high operating expenses, ineffective controls of its varioussubsidiaries and insufficient core earnings.
B. Defendants' Sham Restructuringof NetBank
126. On March 16, 2005 , Defendants filed the NetBank's Form i 0-K for the
fiscal year ended December 31, 2004. That filing reported the Company's financial
condition as of December 31, 2004 and financial results for fiscal year 2004,
including that net income for 2004 was some $4.22 million or $0.09 per share,
compared to net income of some $50.514 million or $1.04 per share, for 2003. That
Filing also described NetBank's operations and its supposed restructuring efforts,
including for example that:
During 2002 and 2003, the retail banking segment implemented anumber of strategies to improve earnings. It restructured its portfolio ofassets away from higher to lower risk loans.
NetBank believes that its deposit base will continue to grow as Internetusage and Internet-based commerce grow. NetBank believes that it cancontinue to invest those deposits profitably in mortgage loans heldtemporarily for sale and loans held for investment. NetBank also
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believes that its non-interest earnings in the form of fees and gain onsale resulting from its financial intermediary and transaction processingactivities will provide a better diversity of earnings than the traditionalbanking model.
127. During a May 4, 2005, conference call with investors, Defendant
Freeman assured investors that not only was the restructuring plan effective , but that
the banking segment was can ying a significant portion of earnings:
We continue to make measurable progress in diversifying your
Company's revenue across its three primary operating segments. You
take a peek for a minute at the long-term view, you see a company with
a strong business plan, a rapidly improving bank that has begun to carry
a significant portion of the Company's earning obligation, and I can't
stress again how much we have improved bank performance over the
past 24 months.
We're now two years into our evolutionary strategic plan. Since the
beginning of the process, we've always felt the Company was a good
investment on the strength of our business plan, capital position, and
management team. This belief is even stronger today given the
measurable progress we've had against many of the critical objectives
we detailed for you. Our top priority has always been to generate
significant rewards for our investors and we think we can do that for
shareholders who share this long-term view.
128. On the strength of defendant Freeman's assurances, NetBank's stock
price rose from $8.38 on May 3, 2005, to $8.53 on May 4, 2005.
129. For a time, the new NetBank's attempt to shift away from its core retail
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banking model under Freeman and Herbert appeared to be working. On August 3,
2005 , defendant Freeman reassured the investing public, stating:
At the bottom line, what investors are getting with Net Bank is as
follows -- a company with an increasingly balanced, stable earnings
profile, an undervalued lending franchise with tremendous earning
power over the full economic cycle, an attractive base of multi-product,
high-value retail bank customers.
130. However, by 2006, due to the combination of the bursting of the U.S.
housing bubble and the mounting exposure from subprime and other risky mortgage
practices, NetBank's operations and finances faced increasing pressure. Demands for
repurchases of loans and defaults increased significantly and investors began to limit
their purchases of mortgage portfolios. As a result, the cash available to NetBank to
lend to borrowers was constrained. This liquidity crisis led NetBank to restructure the
Company to conserve capital and preserve tangible book value. NetBank's purported
"restructuring" had four major components: (1) the sale of its mortgage servicing
platform; (2) the sale or exit of the Company's non-conforming mortgage business;
(3) the sale of other non-core operations; and (4) the raising of capital through a
private placement of NetBank common stock.
131. In February of each year, the NetBank Board of Directors met and
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received a presentation from NetBank's top management regarding the Company's
long-term strategic plan. According to a confidential witness who was a senior
corporate officer ofNetBank during most of the Class Period and who provided input
directly to Freeman, Herbert, and Gross, in February 2006, the NetBank Board of
Directors were aware of the Company 's perilous situation and demanded that the
Company be restructured.
132. On March 15, 2006, NetBank Filed its Form 1.0-K for the fiscal year
ended December 31, 2005, which was signed by defendants Freeman, Herbert,
Muller, Adams, and. Johnson. That filing reported the Company's financial condition
as ofDecember 31, 2005 and financial results for fiscal year 2005, including that the
Company suffered a net loss for 2005 of some $180, 000 or $0.00 per share,
compared to net income of some $4.22 million or $.09 per share, for 2004. The 2005,
Form 10-K also described NetBank's operations and. its supposed restructuring
efforts, including for example that:
In 2003, we announced a strategy to diversify our earnings so that onethird is provided by each of our principal operating segments: retailbanking, financial intermediary and transaction processing. Over thelong-term, our goal is to achieve a better, more stable, balance acrossour different segments.
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133, On May 1, 2006, after repeatedly assuring investors about the success
of its restructuring plan, NctBank began to implement the Board 's February 2006
directive and announced a plan to sell its mortgage servicing platform along with
most of its mortgage servicing rights portfolio. The Company represented that
"[m]anagement estimates such a sale would likely free up between $20 and S35
million in risk-based capital that the company currently has allocated to its servicing
asset . Management would then have the opportunity to redeploy this capital in other
business initiatives that it believes can generate higher returns or better serve
shareholder interest." NetBank also represented that the proposed sale was part of
"management ' s continuous, proactive capital management program ." After years of
purporting to expand its sound core banking strategy to grow and deliver shareholder
value by leveraging those assets, NetBank acknowledged that:
"The economic and market environments have changed dramatically
since we initiated our plan, and we have not been able to achieve the
level of growth in the servicing asset we had anticipated," Freeman
added. "Given prevailing business conditions, we have determined the
mortgage servicing business no longer represents the best use of ourcapital."
"Our obligation first and foremost is to create value for ourshareholders," Freeman concluded. "Although we will continue to planfor the long-term and persist in the face of short-term operational
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pressures when it is right to do so, we will also remain flexible and havethe conviction to revise our business strategy when it clearly furthers theinterest of our shareholders."
Other details or likely results of the proposed sale include:
-The sale would entail a significant one-time restructuring charge.
However, management would seek to moderate the impact of the charge
on the company's tangible book value. The effect on tangible book
value would be part of management's criteria in approving any
transaction.
As of March 31, the company's core servicing asset was comprised of
$ 13.0 billion in loans. Management believes the underlying mortgage
servicing platform could be scaled up to the $35.0 billion mark almost
immediately using the operation's existing facility and infrastructure.
134. On this news, NetBank's stock price rose from $6.84 per share on May
1, 2006 to $6.94 per share on May 2, 2006.
135. On May 2, 2006, a media report in American Banker discussed
NetBank's plan to sell off its mortgage servicing platform and operation. In the
article, Defendant Freeman was quoted portraying the sale as a benefit to the
Company's strong banking segment:
Such a sale would free up to $35 million in risk-based capital -- "a pretty
big number for us," said Douglas K. Freeman, NetBank's chairman and
chief executive. The capital could be redeployed "back into our Internet
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bank or other more profitable activities," he said in an interview. Hewould not say what those other activities were, and he made it clear thathe has no interest in getting into brick-and-mortar retail banking, despiteone analyst's advice that he should. But he reiterated that NctBank isreexamining its game plan. When the capital is freed up, the .$4.8-billionasset company will be able to gather more deposits and increase assets,Mr. Freeman said. "We continue to find great growth on the deposit sideofthe business. ... Your balance sheet has to balance, last time I looked."
1 36. The statements set forth. in the above subsection were materially false
and misleading because they failed to disclose that the Company's financial distress
was due to the failure of its core operations, that selling off parts of its mortgage
business or other non-core operations would not be enough to resuscitate the
Company and that the Company's accounting for its mortgage business was improper.
137. Without disclosing its mounting troubles with the SEC, its auditor E&Y
and its core retail business, on October 5, 2006, NetBank announced that defendant
Herbert would assume the position of CEO, replacing defendant Freeman. In a Form
8.K filed with the SEC on October 5, 2006, defendant Muller confirmed that
NetBank's value was in its core banking business and conforming mortgages, but
omitted discussion of the fact that the Company's non-conforming business was at
that time highly troubled and threatened the viability of the Company itself:
The board believes the company's core strengths reside in its banking
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and conforming mortgage activily..Relentless focus on these operations
is the surest path to increasing shareholder value. We think [Herbert]
is the right person to guide the company through the changes we will
make to pare down costs and leverage these businesses more effectively.
"We believe our bank and conforming mortgage businesses have upside
potential, and I am excited about the prospect of leading the company
in its next stage of development," says Herbert. "Our main objective
over the next three to six months will be to stabilize the company's
operating profile and return to profitability as quickly as possible. As we
mentioned recently, we anticipate announcing a deal to sell the majority
ofourmortgage servicingportfolio soon. We are also actively exploring
alternatives for our non-conforming mortgage business. You will now
see us move quickly to execute on needed changes in other lines of
business outside ofthe core banking and mortgage operations. We have
a talented base ofassociates that I believe will support andfully engage
in this sapid refocus.
138. On this news , NetBank's stock. price rose from $6.30 per share on
October 5, 2006 to $6.33 per share on October 6, 2006.
139. On October 13, 2006, NetBank issued a press release, which was then
filed in a Form 8-K on October 16, 2006 that signed by defendant Gross. That press
release reported that NetBank had sold the servicing rights on $8.5 billion of
mortgages, which represented 70% of its mortgage servicing portfolio, to two buyers,
but took a higher-than-expected $19.3 million loss. NetBank continued to conceal its
difficulties with the SEC by omission. Rather than disclosing the truth, NetBank
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reassured investors by emphasizing that it would no longer have the same level of
exposure to impairment and hedge-related losses. In part, the press release stated:
the company has sold most of its mortgage servicing rights ("MSRs")associated with conventional, agency-eligible loans. These MSRsaccounted for approximately 70% of NetBank's portfolio, and theunpaid principal balance ("UP.B") on the underlying mortgages totaled$8.5 billion. The MSRs were sold in two separate transactions. Thelarger, more significant deal involved MSR.s for Fannie Mae and FreddieMac loans. These MSRs had a related UPB of approximately $8.2billion, and they were acquired by IXIS Real Estate Capital Inc.("IXIS"). A different buyer purchased a pool of Ginnie Mae MSRs withUPI3 of approximately $230 million. Both transactions closed onSeptember 29 and were recognized as third quarter events.
Financial and other details of the sale include:
One-time expenses of approximately $0.61 per share. The combinedsales price for the MSRs was $119 million, which fell below thecarrying value that the company had recognized on these particularMSRs. As a result of this difference, the company recorded an after-taxloss of $19.3 million on the sale. The company also elected to liquidatethe Ginnie Mae mortgage-backed securities that it held as an on-balancesheet hedge. The company recorded an after-tax loss of S8.7 million onthe sale of those securities. These charges along with other transaction-related costs equate to after-tax expenses of $28.1 million or S0.61 pershare.
Limited impact on tangible book value. The sale of the company's on-balance sheet hedges improved the company's equity position on anafter-tax basis by $1.3.8 million or $.30 per share and partially offsets theone-time expenses outlined above at the equity or tangible book level.
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As hedges, the Ginnie Mae securities were valued on a mark-to-marketbasis. The value of these hedges improved throughout the third quarter.The company ultimately realized a smaller loss on these hedges than the
unrealized loss it recognized in its equity calculation on June 30, 2006.x* ::x
"The cost of selling these MSR.s exceeded our initial expectations, but
we believe the entire transaction and the timing of it serve the long-term
interest ofour company and shareholders," said Steven F. Herbert, chief
executive officer. "The transaction immediately improves the operating
profile of'the company as well as our bottom line. By reducing the size
ofour MSR portfolio, we eliminate significant earnings volatility. We
will no longer have the same level ofexposure to impairment and hedge-
related losses. The bank's net interest margin should see incremental lift
following the liquidation ofthe on-balance sheet hedges. We also felt
the intrinsic value ofthe sub-servicing contractprovided a ineaningfid
offset to the lower price."
140. On this news, NetBank's stock price rose from $6.11 per share on
October 13, 2006 to $6.17 per share on October 16, 2006, the next trading day.
141. The statements set forth in the above subsection. were materially false
and misleading because they failed to disclose that the Company' s financial distress
was due to the failure of its core operations , that selling off parts of its mortgage
business or other non-core operations would not be enough to resuscitate the
Company, that the Company' s accounting for its mortgage business was improper and
omitted that the SEC had challenged the Company's improper accounting treatment.
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142. NetBazik's purported "strategic restructuring" continued when, on
November 6, 2006, the Company issued a press release in which it announced that it
had exited its various non-conforming loan financing businesses by selling Meritage
and Beacon. The Company's non-conforming financing operations were so deficient
as to be worthless. In the press release NetBank explained:
The company did not receive any material financial or otherconsiderations under the agreements, but management viewed them asa positive since they allowed the company to mitigate substantialseverance and shutdown costs that the company would likely haveincurred otherwise. Since the agreements did not cover the full scope ofthe operations, the company still has personnel and other commitmentsto address to fully exit both lines of business. Management currentlyexpects to record pre-tax expense of $6.0 million to S7.5 million in thefourth quarter to cover those remaining obligations. The company hadalready written off the goodwill related to both businesses.
"Since the beginning ofOctober, we have been working aggressively torefocus the company on its core banking and confor°mning mortgagecompetencies ," said Steven F. Herbert , chief executive officer.
"We said then that our priorities were to exit or spin off anyunderper_forming or non-core businesses so we cou ld restore thecompany to profitability as quickly as possible and to improve thecompany 's overall operating profile. Our decision to exit the non-conforming mortgage and RV, boat and aircraft lending businessescontribute to those goals in a meaningful way, especially when youconsider the steepness of the quarterly losses we have been incurring inthe non-conforming channel."
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"We also committed to protecting capital as much as possible during this
process," Herbert continued. "We were happy to execute the
transactions that we did since they saved us real dollars in severance and
shutdown costs. But, regardless of the deals, it was critical for us to
move quickly on these businesses. The cost of carrying them for another
quarter or two would have destroyed more value than we probably could
have derived under the best possible transaction circumstances."
The company announced its plan to refocus on its banking and
conforming mortgage operations along with a change in executive
leadership on October 3, 2006. Ivlanagelment has indicated that it
intends to exit the lines ofbusiness it considers non-core and to make
any other related business adjustments by the end ofthefirst quarter of
2007, although it hopes to complete the bulk of the effort by the end of
2006.
143. The statements in the above subsection were materially false and
misleading because they failed to disclose that the Company' s financial distress was
due to the failure of its core operations, that selling off parts of its mortgage business
or other non-core operations would. not be enough to resuscitate the Company and
that the Company's accounting for its mortgage business was improper. In addition,
it failed to disclose that the Company' s tangible book value was declining rapidly,
even with the restructuring , due to the failure of the Company' s core businesses.
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C. Defendants Falsely Assure Investors That TheyCan Rev on NetBank's Book Value
144. On May 4, 2005, NetBank held a conference call with analysts and
others to discuss the Company's financial results for the first quarter of2005. During
that call, Defendant Freeman stated:
Book values slipped by $0.20 to $8.70 during the quarter. The declinein interest rates environment experienced during the quarter affected thevalue of securities and the banks investment portfolio, most of thedecrease in book values attributable to an unrealized loss of netportfolio. I point out that this is simply a one-dimensional view. Overtime we fully expect book value to trend upward.
1.45. In an effort to mislead investors into believing that the NetBank's book
value was an accurate measure of their investment, NetBank continued to repurchase
shares of its common stock and continued to reassure investors about the value of
those shares. For example, during NetBank's May 4, 2005, conference call with
analysts, Defendant Freeman reported:
The Board of Directors approved a dividend of $0.02 per share andauthorized an additional 1 million shares for our stock repurchaseprogram. As we reported in the press release, we repurchasedapproximately 424,000 shares at an average price of $9.29 per shareduring the quarter. As current tradingprice, we continue to believe thatour stock represents the best investment ofavailable capital.
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146. Less than one year later, on May 1, 2006, NetBank announced a plan to
sell its mortgage servicing platform along with most of its portfolio of mortgage
servicing rights. However, recognizing the importance investors placed on NetBank's
book value as a measure of their investment, NetBank assured investors that it would
undertake to moderate the impact from the sale on the Company's tangible book
value as follows:
Other details or likely results of the proposed sale include:
• The sale would entail a significant one-time restructuring charge.
However, management would seek to moderate the impact ofthe charge
on. the company's tangible book value. The effect on tangible book
value would be part of management's criteria in approving any
transaction.
147. fn a November 8, 2006 press release NetBank explained:
Tangible book value is defined as total shareholders' equity reduced byrecorded goodwill and other intangible assets. Tangible book value pershare is defined tangible book value divided by total common sharesoutstanding. These non-GAAP financial measures exclude from totalshareholders' equity our recorded goodwill and other intangible assets.Management believes that these non-GAAP financial measures, whenconsidered together with the GAAP financial measures, provideinformation may be helpful for those investors who seek to evaluate ourtotal stockholders' equity without giving effect to goodwill and otherintangible assets. Management also believes that these non-GAAPfinancial measures enhance the ability of investors to analyze thecompany's business trends and to better understand the company's
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financial condition . In addition , the company may utilize non-GAAP
financial measures as a guide in its forecasting, budgeting, and
long-term planning process and to measure operating performance for
some management compensation purposes . Any analysis ofnon-GAAP
financial measures should be used only in conjunction with amounts
presented in accordance with GAAP, including total shareholders' equity
and goodwill and other intangible assets.
148. According to BuusinessWeek.coyrn:
Tangible book value indicates the theoretical dollar amount per common
share one might expect to receive from a company's tangible "book"
assets should liquidation take place.
Generally, book value is determined by adding the stated value of the
common stock, paid-in capital and retained earnings, and then
subtracting intangible assets (excess cost over equity of acquired
companies, goodwill and patents), preferred stock at liquidating value
and unamortized debt discount. Then divide that amount by the
outstanding shares to get book value per common share.
149. On May 10, 2006, NetBank held an conference call with analysts and
others to discuss the Company's financial results for the first quarter of 2006.
Significantly, NetBank knew and understood that investors were valuing the
Company based on its book value, and understood the need to avoid negatively
impacting that calculation, notwithstanding other financial realities. For example, the
same May 2, 2006, American Banker article quoted above noted that investors priced
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NetBank's shares on the basis of book value, and not on the basis of earnings, and as
a result, a larger than expected restructuring charge for the sale of its mortgage
servicing rights would hurt bookvalue and, in turn, the Company's stock price. Thus,
the Defendants knew that it was imperative that they continue to reassure investors
about the Company's book value and to ignore certain financial realities in favor of
minimizing any negative impact on the Company's book value.
1.50. On November 8, 2006, NetBank announced its operating results for its
third quarter ended September 31, 2006. NetBank reported dramatic losses of $73.3
million or $1.58 per share for the quarter, compared with an after-tax loss of S 1.4
million or $0.03 per share during the sane quarter in the prior year. In part, the press
release stated that NetBank:
a leading mortgage lender, today reported financial results for the
quarter ended September 30, 2006. The company recorded an after-tax
loss of $73.3 million or $1.58 per share for the period, compared with
an after-tax loss of $1.4 million or $.03 per share during the same
quarter a year ago. On a year-to-date basis, the company recorded an
after-tax loss of $116 million or $2.50 per share, versus a net loss of
$1.1 million or $.02 per share during the first nine months of 2005.
Book value declined by $1.22 per share from $7.48 on. June 30, 2006 to
$6.26 on September 30, 2006. However, the impact on the company's
tangible book value was substantially less. Tangible book value declined
$.70 per share from $5.80 on June 30, 2006 to 55.10 on September 30,
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2006. On an after-tax basis, the reported loss included a $19.5 million
expense of non-deductible goodwill and a $2.4 million expense of
deductible goodwill, both of which did not negatively impact tangible
book value. In addition, the company sold certain on-balance sheet
investments allocated as economic hedges of its mortgage servicing
rights ("MSRs") during the quarter. The Unrealized loss on these
securities was already deducted from tangible book value on June 30
through other comprehensive loss included in the equity section of the
balance sheet. Thus, the realized loss on those securities did not impact
tangible book value. (Details related to amounts excluded from tangible
book value are provided in the attached Reconciliation of Non-G.AAP
Financial Measures.)
1 51 . The statements set forth in the above subsection were materially false
and misleading because they failed to disclose that the Company's financial distress
was due to the failure of its core operations, that selling off parts of its mortgage
business or other non-core operations would not be enough to resuscitate the
Company and that the Company's accounting for its mortgage business was
improper. In addition, it failed to disclose that the Company's tangible book value
was declining rapidly even with the restructuring due to the failure of the Company's
core businesses.
D. Defendants Make Additional False Assurances to
Investors After E&Y Resigns
152. On November 9, 2006, Defendant Gross signed a Form S-K filed by
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NetBank with the SEC. In the Forin 8-K, the Company revealed that on October 10,
2006, E&Y had resigned as NetBank's independent auditor. E&Y's resignation as the
Company's independent accountant became effective on November 9, 2006, with the
filing of the Company's Quarterly Report on Forln 10-Q for the three-month and
nine-month periods ended September 30, 2006.
153. In NetBank's November 9, 2006, Form 8-K, Defendants discussed
certain material weaknesses in the Company's internal controls, stating:
In the Company's Annual Report on Form 10-K for the fiscal year ended
December 31, 2004, which the Company filed with the SEC on March
16, 2005, Management's Annual Report on Internal Control over
Financial Reporting stated, and E&Y's report on internal controls
reiterated, that because of the material weakness disclosed in those
reports, the Company's internal control over financial reporting was not
effective as of December 31, 2004, based on the criteria set forth by the
Committee of Sponsoring Organizations of the Treadway Commission
in Internal Control - Integrated Framework. The material weakness in
those reports concerned the Company's controls over the determination
and estimation of the change in fair value of the Company's portfolio of
mortgage loan funding commitments where the interest rate had been
locked and the related financial derivatives ("rate locks"). In 2005, the
Company implemented certain changes to its internal controls to address
the material weakness over the Company's rate locks and determined
that the material weakness existing at December 31, 2004 was corrected.
154. Item 4.01(a) of Form 8-K requires the registrant, here NetBank, to
disclose the information required by Regulation S-K Item 304(a)(1) and Item
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304(a)(3) when its auditor resigns. The disclosures required by Regulation S-K Item
304(a)(I) regarding disagreements between a registrant and its auditor include: (iv)
state whether during the registrant 's two most recent fiscal years and any subsequent
interim period preceding such resignation, declination or dismissal there were any
disagreements with the former accountant on any matter of accounting principles or
practices, financial statement disclosure, or auditing scope or procedure, which
disagreement(s), if not resolved to the satisfaction of the former accountant, would
have caused it to make reference to the subject matter of the disagreement(s) in
connection with its report. Also, (A) describe each such disagreement; (B) state
whether any audit or similar committee of the board of directors, or the board of
directors , discussed the subject matter of each of such disagreements with the former
accountant; and (C) state whether the registrant has authorized the former accountant
to respond fully to the inquiries of the successor accountant concerning the subject
matter of each of such disagreements and, ifnot, describe the nature ofany limitation
thereon and the reason therefore. The disagreements required to be reported in
response to this Item include both those resolved to the former accountant's
satisfaction and those not resolved to the former accountant's satisfaction.
Disagreements contemplated by this Item are those that occur at the decision-making
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level, i.e., between personnel of the registrant responsible for presentation of its
financial statements and personnel of the accounting firm responsible for rendering
its report.
155. By virtue of filing Netbank's November 9, 2006 Form 8-K, Defendants
violated Item 4.01(a) and the related disclosure requirements by falsely representing
that there were no material disagreements between the Company and E&Y, as
follows:
During each ofthe fiscal years ended December 31, 2004 and December
31, 2005 and the subsequent interim period from January 1, 2006
through the effective date of E&Y's resignation on November 9, 2006:(i) there were no disagreements between the Company and E&Y on any
matter of accounting principles or practices, financial statement
disclosure, or auditing scope or procedure, which disagreements, if not
resolved to the satisfaction of E&Y, would have caused E&Y to make
reference to the subject matter of the disagreement in connection with
its reports on the consolidated financial statements for such years; and
(ii) except as set forth in the next paragraph, there were no "reportable
events" (as defined in Item 304(a)(1)(v) of Regulation S-K).
156. NetBank facilitated the foregoing false and misleading statement in the
Form 8-K by stating, "The Company has provided E&Y with a copy of the above
disclosures and has requested that E&Y furnish the Company with a letter addressed
to the SEC stating whether it agrees with such statements made by the Company. A
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copy ofthat letter, dated November 9, 2006, is attached hereto as Exhibit 16.1." E&Y
had certified to the SEC on November 9, 2006, that "We have read Item 4.01 ofForm
8-KJA dated November 9, 2006, of NetBank, Inc. and are in agreement with the
statements contained in the first four paragraphs in the section, "Item 4.01 Changes
in Registrant's Certifying Accountant." Included among the "first four paragraphs"
referenced by E&Y in its November 9, 2006, certification was NetBank's foregoing
certification that were no disagreements between the Company and E&Y.
157. Despite the representations of NetBank and E&Y, according to a
confidential witness, who was a senior executive ofNetBank during the entire Class
Period, and who had regular daily interaction with defendants Freeman, Herbert and
Gross, E&Y had a significant ongoing disagreement with NetBank regarding the
calculation of the Company's hedge effectiveness under SFAS 133.
158. NetBank had an inventory of mortgages for which they maintained
servicing rights. Under FAS 133, NetBank was required to show its hedge
effectiveness relating to those rights and perform calculations on a monthly basis.
However, according to a confidential witness who was a senior executive ofNetBank
during the entire Class Period and who had regular daily interaction with defendants
Freeman, Herbert and Gross, E&Y advised NetBank and its senior management that
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the Company's hedge effectiveness testing under FAS 133 was not being conducted
frequently enough to be reliable and directed NetBank to perform the hedge-
effectiveness on a daily basis. E&Y also directed NetBank to re-calculate the hedge-
effectiveness for previous years back to 2002.
159. According to a confidential witness, who was a senior executive of
NetBank during the entire Class Period, and who had regular daily interaction with
defendants Freeman, Herbert and Gross, NetBank was also in negotiations with the
SEC regarding the frequency with which it performed its hedge-effectiveness under
FAS 133. NetBank ultimately reached an agreement with the SEC in which the SEC
would permit NetBank to perform a re-calculation for one month out of each quarter
in an attempt to demonstrate that the hedging was effective, However, E&Y refused
to accept the proposal claiming that it did not believe that it was adequate solution.
For its part, NetBank and its senior management, upon information and belief, refused
to accept the assessment ofE&Y. On the basis of that disagreement between NetBank
and E&Y, E&Y resigned as Netlank's auditors.
160. According to a confidential witness who was a NetBank officer
employed in the Corporate Finance Department throughout the Class Period and who
had direct dealings with top management including defendant CFE Herbert, E&Y
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also told NetBank that E&Y was resigning because it was not comfortable with the
Company 's financial statements.
161. According to a confidential witness who was a senior corporate officer
of NetBank during most of the Class Period and who provided input directly to
defendants Freeman, Herbert, and Gross, E&Y also claimed that its decision to
resigned was motivated , at least in part , by its fear of the "potential liability
associated with NetBank."
162. According to a confidential witness who was a high-level manager in
NetBank's Finance Department during the entire Class Period and who reported to
Herbert and, later Gross, among others, defendants Herbert and Gross were "furious"
with E&Y' s decision to resign as NetBank ' s auditors and claimed to believe that
E.&Y did so in an effort to distance itself from NetBank.
163. Despite the serious disagreements between NetBank and E&Y and their
mutual omission ofthose disagreements , NetBank attempted to further downplay the
reasons for E&Y's resignation, stating that "[t]he audit reports of E&Y on the
Company's consolidated financial statements for the fiscal years ended December 31,
2004 and 2005 did not contain an adverse opinion or a disclaimer ofopinion and were
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not qualified or modified as to uncertainty, audit scope or accounting principles."
164. Although it could no longer fail to inform the investing public that E&Y
had resigned as NetBank's auditor, Defendants also continued to omit that months
before NetBank had received a comment letter from the SEC regarding the
Company's application of SFAS 133 to the accounting of its mortgage servicing
rights and loans held for sale.
165. With these reassurances, NetBank's stock price increased from $4.99 per
share on November 9, 2006 to 55. 02 per share on November 10, 2006.
1.66. E&Y also continually refused to re-issue its 2004 and 2005 audit report
for inclusion in NetBank's 2006 Fonn 10-K unless and until NetBank resolved the
SEC's dispute with respect to the Company's application of FAS 133 to the
accounting of mortgage servicing rights and loans held for sale. By the time of its
collapse, NetBank had never resolved. the SEC's issues or filed audited financial
results for 2006.
167. The statements set forth in the above subsection were materially false
and misleading because they failed to disclose that the Company's financial distress
was due to the failure of its core operations, that selling off parts of its mortgage
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business or other non-core operations would not be enough to resuscitate the
Company and that the Company's accounting for its mortgage business was
improper. NetBank also omitted that, in fact, the reason for the failure to timely file
was Defendants' failure to comply with GAAP in valuing its core mortgage portfolio
and, as a result, its tangible book value.
168. On January 3, 2007, in the final phase of its purported restructuring,
NetBank announced a private placement of 6,500,000 shares of its common stock at
a price of $3.90 per share, with proceeds of approximately $23.7 million.
169. The private placement closed on January 5, 2007. On January 8, 2007,
NetBank issued a press release, which was then filed in a Form 8-K on that same day
which was signed by defendant Gross. That press release stressed that this was one
of the final steps in its restructuring and was intended to, among other things,
"maintain [NetBank's] optimum capitalization". In part, the press release stated:
"We are pleased with the transaction and believe it serves the best
interest of long-term shareholders," said Steven F. Herbert, chief
executive officer. "We are in the final phase of the corporate
restructuring plan we started three months ago. The plan centers on
returning the company to profitability as quickly as possible by exiting
underperforming businesses and refocusing attention on our core retail
and small business banking operations as well as our prime mortgage
businesses. We believe the additional capital will allow us to maintain
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optimal capitalization within the bank; support new asset and deposit
growth; and potentially invest in other key initiatives."
"We were deliberate in balancing the benefit of additional capital with
the dilution to existing shareholders that this transaction represents,"
Herbert continued. "By limiting the issuance to a relatively small
number of shares, we were able to keep the dilution to approximately
$0.10 per share based on a closing market price of $4.64 the day that we
priced the deal."
170. As a result of expected dilution of NetBank shares, NetBank's stock
price slipped in a roughly equal amount, from $4.30 per share on January 3, 2007 to
$4.14 per share on January 5, 2007.
171. The statements set forth in the above subsection were materially false
and misleading because they failed to disclose that the Company's financial distress
was due to the failure of its core operations, that selling off parts of its mortgage
business or other non-core operations would not be enough to resuscitate the
Company and. that the Company's accounting for its mortgage business was
improper.
172. On January 3, 2007, in a Form 8 -K Filed with the SEC in connection with
the private placement discussed above, NetBank informed investors for the first time
that as a result of E&Y's resignation on October 10, 2006,and the Company's
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inability to find a replacement auditor, the filing of its 2006 Form 10-K might be
delayed. NetBank also revealed that the Company's stock may be delisted by the
NASDAQ stock exchange if the 2006 Form 10-K was not filed by March 16, 2007.
17 3. Despite the potentially dire consequences delisting would have on
NetBank's common stock and its public shareholders, the Company downplayed the
problem. Rather, it reassured investors by falsely claiming that the Company simply
had not yet been able to find a replacement despite the efforts of NetBank's Audit
Committee and that there had been no disagreements between NetBank and Ernst &
Young:
On October 10, 2006, Ernst & Young LLP ("E&Y"), the independent
registered public accounting firm of the Company for the fiscal year
ended December 31, 2005, resigned effective upon the filing with the
Commission of the Company's Quarterly Report on Form 10-Q for the
three-month and nine-month periods ended September 30, 2006. E&Y's
resignation as the Company's independent registered public accounting
firm became effective on November 9, 2006, with the filing of the
Company's Quarterly Report on Form 10-Q for the three-month and
nine-month periods ended September 30, 2006. During each ofthe fiscal
years ended December 31, 2004 and December 31, 2005 and the
subsequent interim period from January 1, 2006 through the effective
date of E&Y's resignation on November 9, 2006 there were no
disagreements between the Company and E&Y on any matter of
accounting principles or practices, financial statement disclosure, or
auditing scope or procedure, which disagreements, if not resolved to the
satisfaction of E&Y, would have caused E&Y to make reference to the
subject matter of the disagreement in connection with its reports on the
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consolidated financial statements for such years.
Since prior to the effective date of E&Y's resignation, the Audit
Committee of the Board of Directors of the Company has been engaged
in the process of selecting an independent registered public accounting
firm ("Auditor") for the fiscal year ending December 31, 2006.
174. As a result of NetBank's reassurances, its stock price remained stable,
closing at $4.30 per share on both January 3 and 4, 2007.
175. The statements set forth in the above subsection were materially false
and misleading in that they falsely led investors to believe that the delay in filing the
2006 Form 10-K was not due to a. substantive issue, but rather was merely the
procedural result of not being able to engage an auditor in time to file. These
statements omitted to state that in fact, the reason. for the failure to timely file was the
Defendants ' s failure to comply with GAAP in valuing its core mortgage portfolio
and, through that, its tangible book value.
176. More than three months after E&Y's resignation, in a February 16, 2007
idling with the SEC on Form 8-K, NetBank announced that it had selected Porter
Keadle Moore , LLP ("PKM"), as its new independent auditor and repeated the false
and misleading statement that it was the procedural delay in selecting a new auditor
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that might prevent NetBank from timely filing the 2006 Form. 10-K. Further
misleading investors, the Company falsely represented to shareholders that it
expected to file the 2006 Form. 10-K no later than June 31, 2007:
On February 13, 2007, NetBank, Inc. (the "Company") engaged PorterKeadle Moore, ,LP ("PKM") as its new independent registered publicaccounting firm for the fiscal year ended December 31, 2006.
[DJue to the timing ofthe engagement ofPKk[, the Company does notexpect that PKMwill be able to perform and complete the audit ofour2006 financial statements, and related auditor attestation regarding ourinternal control over financial reporting, by our compliance deadlineof'Mareh 16, 2007, the last date the Company is permitted to timely fileits Annual Report on Form 10-K for the year ended December 31, 2006("2006 Form 10-K") with the SEC. The Company currently believes thatthe 2006 audit will be completed in June 2007 and expects to file the2006 Form 10-K with tie SEC on or before June 30, 2007, although noassurance can be given.
177. On February 21, 2007, NetBank issued a press release, which was then
filed in a Form S-K on that same day which was signed by defendant Gross. That
press release announced the Company's preliminary unaudited results for the year
ended December 31, 2006. Attempting to explain why it was still unable to issue final
audited results, NetBank again created the impression that the only reason the filing
of its 2006 Form l 0-K may be late was that PKM had only been "recently engaged"
and that it expected the 2006 Form 10-K would be filed soon stating:
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The results set forth in this press release are preliminary and unaudited.
As previously reported, the company recently engaged Porter Keadle
Moore, LLP ('PKM'' ) to replace Ernst & Young LLP as its independent
auditor. These preliminary results are subject to potential adjustments,
which may be material, arising from subsequent events or the audit of
the company's financial statements for the year ended December 31,
2006 by PKM. The company currently believes that the 2006 audit, and
related auditor attestation regarding the company's internal control over
financial reporting, will be completed in June 2007 and expects to file
its Annual Report on Form I 0-K for the 2006 fiscal year with the SEC
on or before June 30, 2007, although no assurance can be given.
178. As a result of defendants' false assurance on February 16 and 21, 2007,
NetBank's stock rose from $3.55 per share on Friday, February 16, 2007 to $3.62 per
share on February 21, 2007.
179. The statements set forth in the above subsection were materially false
and misleading in that they falsely led investors to believe that the delay in filing the
2006 Form 10-K was not due to a substantive issue, but rather was merely the
procedural result of not being able to engage an auditor in time to file . These
statements omitted to state that in fact, the reason for the failure to timely file was the
failure of Defendants to comply with GAAP in valuing its core mortgage portfolio
and, through that, its tangible book value.
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E. NetBank Continues to Falsely Reassure Investors About
the Company's Condition and Operations
180. On February 21, 2007, NetBank announced its preliminary unaudited
results for the year ended December 31, 2006. NetBank recorded an after-tax loss of
$86.3 million or $1.86 per share during the fourth quarter, compared with net income
of $895,000 or $0.02 per share during the same quarter in 2005. NetBank further
recorded a net loss of $202 million or $4.36 per share for the full year, compared with
a net loss o f $180,000 or 50.00 per share for 2005.
181. The February 21, 2007 report of NetBank's fourth quarter and year end
2006 financial results also contained a section called "Key items worth noting" in
which management represented that the "worst of the non-conforming loan
repurchase problem is now behind the company" and that the impact of the
restructuring on the Company's tangible book value was "lessened, being reduced
only to $3.50 on December 31, 2006 from $5.10 on September 30, 2006." The press
release also stated:
Management believes the worst of the non-conforming loan repurchaseproblem is now behind the company given the accelerated repurchaserequests already received relative to the limited non-conformingproduction over the second half of 2006.
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Impact on Tangible Book Value Lessened. Book value declined by
$1.94 per share from $6.26 on September 30, 2006 to $4.32 on
December 31, 2006. However, the impact on the company's tangible
book value was less. Tangible book value declined by $1.60 per share
from $5.10 on September 30, 2006 to $3.50 on December 31, 2006. Oil
an after-tax basis, the reported loss included the $9.7 million write down
related to the company's ATM and merchant processing business
mentioned above that did not negatively impact tangible book value.
(Details related to amounts excluded from tangible book value are
provided in the attached Reconciliation of Non-GAAP Financial
Measures.)
182. The statements set forth in the above subsection were materially :false
and misleading because they failed to disclose that the Company's financial distress
was due to the failure of its core operations, that selling off parts of its mortgage
business or other non-core operations would not be enough to resuscitate the
Company and that the Company' s accounting for its mortgage business was
improper. In addition, it failed to disclose that the Company's tangible book value
was becoming worthless even with the restructuring due to the failure of the
Company's core businesses.
183. The February 21, 2007 announcement orNetBank's fourth quarter and
year end 2006 financial results also contained a section called "Management
Commentary" in which Defendant Herbert told investors that "in the span of 90
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days," NetBank was able to "substantially execute a restructuring plan designed to
stabilise the company's operating profile and capital position," and that the Company
had .finally "emerged" from the "tunnel" of the restructuring having moved closer to
NetBank's goal ofrestoring profitability and stabilizing book value.The press release
stated, in part:
"I'm proud of the fact that, in the span of 90 days, we were able to
substantially execute a restructuring plan designed to stabilize the
company's operating profile and capital position. During the quarter, we
sold, exited or shut down our non-conforming mortgage operation; our
RV, boat and aircraft financing business; FTI and the QuickPost service;
and Netlnsurance. We consolidated two of our indirect conforming
mortgage operating centers into our Columbia facility, and during
December, we substantially effected a shut down of our auto lending
unit.
The final item remaining to be checked off our 'to do' list is the
completion of the sale of our ATM and merchant processing business.
We have a non-binding letter of intent in place and we are optimistic
that a definitive agreement will be reached soon and the deal will close
by the end of the first quarter. T am also pleased that we can check off
'engage an audit firm' which wasn't on our original list of things to do.
"When we began this process, T likened it to driving through a tunnel.
We had a roadmap, but we went in not knowing exactly what things
would look like on the other side. Now that we've emerged, were
evaluating our next steps.
"I'd be remiss if I didn't thank our associates for all the hard work they
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have done since last October. That work has moved us closer to our goal
ofrestoring profitability and stabilizing book value . While we evaluate
our next steps , our operating priorities will continue to be moving our
indirect conforming mortgage operation back toward breakeven as
quickly as possible and generating cost-effective deposit growth at the
bank."
184. As a result of this news and NetBank's reassurances, the Company's
stock price rose from $3.57 per share on February 20, 2007 to $3.62 per share on
February 21, 2007.
185. The statements set forth in the above subsection were materially false
and misleading because far from successfully executing a plan that "stabilize[d] the
company's operating profile and capital position" or "emerg[ing]" from the "tunnel"
of the restructuring, Defendants failed to disclose that the Company's financial
distress was due to the failure of its core operations, that selling off parts of its
mortgage business or other non-core operations would not be enough to resuscitate
the Company and that the Company's accounting for its mortgage business was
improper. In addition, it failed to disclose that far from "stabilizing book value," the
Company's tangible book value was declining rapidly even with the restructuring and
cash infusion due to the failure of the Company' s core businesses.
186. On March 23, 2007, NetBank filed a Form. 8-K with the SEC, which was
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signed by defendant Gross and which attached a press release of the same date. That
attached press release announced that on March 20, 2007, the Company had received
a letter from the NASDAQ stating that NetBank's inability to file timely the 2006
Form 10-K served as a basis for its stock to be delisted. NetBank thereby further
perpetuated the falsehood that the only reason. For its failure to timely file the
Company's 2006 Form 10-K was the delay in retaining new independent auditors
after the resignation of E&Y. In the press release NetBank:
announced that on March 20, 2007, it received a staff determination
notice from the Nasdaq Stock Market stating that the company's
common stock is subject to delisting.
As previously reported, the company was unable to timely file its 10-K
due to the delay in engaging a new independent auditor after its former
independent auditor resigned effective 1'ovem.ber 9, 2006. On February
15, 2007, the company reported that it engaged Porter Keadle Woore,
LLP ("PKM") to replace Ernst & YoungLLPas its independent auditor.
The company currently believes that the 2006 audit, and related auditor
attestation regarding the companys internal control over financial
reporting, will be completed in June 2007 and expects to file its 10-K
with the SEC on or before June 30, 2007, although no assurance can be
given.
187. On this news, NetBank's stock price rose slightly from $2.41 per share
on March 23, 2007 to $2.42 per share on March 26, 2007, the next trading day.
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188. On May 14, 2007, NetBank received an additional NASDAQ "Notice
of Non-Compliance" advising the Company of an additional basis for the del i sting
of the Company's common stock.
189. On May 15, 2007, NetBank issued a press release and a Form. 8-K,
signed by defendant Gross, in which it announced that it had received a letter from
the NASDAQ stating that while the Company had released preliminary unaudited
results for the December 31, 2006 year, the year-end statements would remain open
to "additional evidence with respect to conditions that existed at the date of the
balance sheet and affect estimates inherent in the process of preparing the audited
financial statements," and for the first time indicated that this may require NetBank
to "push back" and record certain unidentified "subsequent events" in its year-end
financial statements . In relevant part, the Netl3ank press release stated:
As previously announced, the company received a similar letter on
March 20, 2007, when it was unable to timely file its Annual Report on
Form 10-K for the fiscal year ended December 31, 2006 (the "10-K").
In response to that letter, the company requested, and was granted, a
hearing before a NASDAQ Listing Qualifications Panel. The hearing
was held on. May 3, 2007. During the hearing, the company presented
its plan for regaining compliance. Since the company is unable to file
its I0-Q before its 10-K has been filed, management currently expects
to file the 10-K and IO-Q concurrently on or before June 30, 2007,
although no assurance can be given.
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The company also announced that it will delay reporting its results for
the quarter ended March 31, 2007, until its auditors have completed the
audit of the company's financial statements for the year ended December
31, 2006, and the company has filed the 10-K. While the company
reported preliminary, unaudited results for its year ended December 31,
2006, the subsequent events period applicable to our financial
statements for the year ended December 31, 2006, will remain open until
the completion of the audit. Under applicable accounting
pronouncements, events that occur or information that becomes
available subsequent to the December 3.1, 2006, balance sheet date but
before issuance of the year-end audited financial statements that
provide additional evidence with respect to conditions that existed at the
date ofthe balance sheet and affect the estimates inherent in the process
ofpreparing the auditedfinancial statements would be required to be
"pushed back " and recorded in the year-end ,financial statements. The
company currently expects that it may be required to "push back" and
record in its year-end financial statements certain subsequent event
items in accordance with these accounting pronouncements. However,
until the subsequent events period is closed, the company will not be in
a position to review or quantify such charges or their effect o its
previously reported preliminary, unaudited results at year-end. Upon
reporting final year-end and first quarter results, the company will
identify the nature and amount ofcharges, if'any, that were required to
be pushed back to 2006.
As previously reported, the company was unable to timely file its 10-K
due to the delay in engaging a new independent auditor after its former
independent auditor resigned effective November 9, 2006. On February
15, 2007, the company reported that it engaged Porter Keadle Moore,
LLP ("PKM") to replace Ernst & Young LLP as its independent auditor.
190. On this news, NetBank's stock price dropped slightly from $1.95 per
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share on May 15, 2007 to $ I.90 per share on May 1. 6, 2007.
191. The statements set forth in the above subsection were materially false
and misleading in that they falsely led investors to believe that the delay in filing the
2006 Form 10-K was not due to a substantive issue, but rather was merely the
procedural result of not being able to engage an auditor in time to file. These
statements omitted to state that in fact, the reason for the failure to timely file was the
failure of Defendants to comply with GAAP in valuing its core mortgage portfolio
and, through that, its tangible book value.
192. According to a confidential witness who was a senior executive of
NetBank during the entire Class Period, and who had regular daily interaction with
defendants Freeman, Herbert and Gross, although PKM conducted a 2006 full-year
audit, the SEC would not accept the PKM full-year 2006 audit unless E&Y approved
it and reissued its prior certifications, which E&Y continually refused to do.
193. According to another confidential witness who was a senior executive
of NetBank during the entire Class Period and who interacted daily with Herbert,
Freeman and Gross, E&Y's continued refusal was a contributing factor to the demise
of NetBank. The Defendants were aware that if E&Y refused to certify NetBank's
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financials, making it impossible for NetBank to file Financial statements with the
SEC, the Company's stock would eventually be delisted. E&Y continued to refuse
to certify NetBank's financials. As a result, the Company was assessed penalties by
the FDIC for a lack of timely audit, which ultimately led to the Company's stock
being delisted. The Defendants also knew and understood that if the NetBank lost its
SEC certification the Company could not maintain its WLC which, as alleged above,
was. essential to the continuation of its subprime mortgage operations at Meritage.
194. In the midst of making materially false and misleading statements
regarding its failure to timely make required filings with the SEC, NetBank continued
to sell off assets in an effort to raise capital, many of which were crucial to its core
operations.
195. On May 1, 2007, NetBank issued a press release in which it announced
that it sold. its ATM and Merchant Servicing Operation for $18 million, which
included initial cash proceeds of $16.5 million. Defendant Herbert portrayed this sale
as a "win-win" that would increase NetBank's tangible assets and tangible book value
even though he admitted that "NetBank was carrying the assets on its balance sheet
at a higher value than the sales price" and, therefore, the Company would "record an
additional impairment charge of approximately $2.0 million to bring the book value
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of the assets into line with the sales price." More fully, the press release stated, in
part:
NetBank Payment Systems sold its principal operating assets and net
working capital yesterday to PAT ATM Services, LLC, a subsidiary of
Payment Alliance International, Inc. ("PAT"). The assets consisted
primarily of servicing contracts on more than 8,500 ATMs nationwide.
The sales price for the assets totaled S18.0 million, resulting in initial
cash proceeds of $1.6.5 million after adjustment for the estimated book
value of the net working capital acquired.
NetBank was carrying the assets on its balance sheet at a higher value
than the sales price. The bank will therefore record an additional
impairment charge of approximately $2.0 million to bring the book
value of the assets into line with the sales price. It is important to note
that the ATM servicing contracts were recognized on the bank's balance
sheet as intangible assets. Through the sale, the bank monetized them
and thus converted them from an intangible into a tangible. This means
the bulk. of the cash proceeds represents new tangible capital that
management can put to work in additional asset growth at the bank or
other cost-saving initiatives. It also directly increases the company's
overall tangible book value.
"We mentioned several months ago our intention to sell this operation
as part ofour larger corporate reorganization ofjbrt," said Steven F.
Herbert, ChiefExecutive Officer ("CEO"), NetBank, Inc. "We said then
that the operation was well managed and had real value. But, it simply
did not fit in with our core banking and mortgage focus. It required
significant capital to operate and therefore represented a strain or
distraction on our resources."
"The deal with PAT is a win-win proposition," Herbert concluded. "PAT
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will be able to invest more in the operation and preserve the jobs of thetalented team we had in place. In turn, we have generated significant
new tangible capital. This money will prove important in our effort tomaintain proper regulatory capital ratios and to protect shareholder
value as we fight to get the company back on track financially throughfurther restructuring or other alternatives."
196. On these reassurances to the market that NetBank actually had increased
its tangible book value in this further stage of the restructuring, the Company's stock
price rose from $1.96 per share on May 1, 2007, to $2.07 per share on May 2, 2007.
197, The statements set forth in the above subsection were materially false
and misleading because far from being a "win" for NetBank that generated additional
capital for turning around the Company, as Defendants well-knew, no amount of
additional funding would save the Company since its financial distress was so deeply
rooted in the failure of its core operations and that its 2004 and 2005 financial
statements were false and misleading and could not he relied upon by the investing
public. In addition, it failed to disclose that the Company's tangible book value in fact
continued to decline rapidly even with the restructuring and multiple cash infusions
due to the failure of the Company's core businesses.
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F. NetBank Misleads Investors Regarding the Validity
of Its FAS 133 Accounting
198. From at least March 16, 2005 through November 9, 2006, NetBank
issued financial reports that were materially false and misleading, primarily due to its
failure to comply with Statement of Financial Accounting Standard ("SFAS") 133.
The misrepresentations had the result of achieving management's desire to mask the
fact that its revolutionary business model implemented through, in substantial part,
its non-conforming mortgage loan business, was a sham.
199. In June 1998, the FASB released SFAS 133 which required that, after
January 1, 2001, derivatives be accounted for at fair market value. The standard
essentially provides that derivatives must be revalued every reporting period, and
changes to value must be reported in the income statement. To achieve hedge
accounting in compliance with SFAS 133, a company must associate each derivative
contract with the specific liability, asset or forecasted transaction being hedged.
200. The Financial Accounting Standards Board issued Statement ofFinancial
Accounting Standards ("SFAS" or "FAS") No. 133 in June of 1998. SFAS 133
governs "Accounting for Derivative Instruments and Hedging Activities." SFAS 133
establishes accounting and reporting standards for derivative instruments, including
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certain derivative instruments embedded in other contracts, (collectively referred to
as derivatives) and for hedging activities. SFAS 133 was issued because the effects
of the increasing quantity and variety of derivatives used by companies were not
transparent in the financial statements. SFAS 133 standardizes the accounting
treatment for derivative instruments by requiring all. entities to report derivatives as
assets and liabilities on the balance sheet at their fair value.
201. Under SFAS 133, if certain conditions are met, a derivative may be
specifically designated as: (a) a hedge of the exposure to changes in the fair value of
a recognized asset or liability or an unrecognized firm commitment; (b) a hedge ofthe
exposure to variable cash flows of a forecasted transaction; or (c) a hedge of the
foreign currency exposure ofa net investment in a foreign operation, an unrecognized
firm commitment, an available-for-sale security, or a foreign-currency-denominated
forecasted transaction.
202. NetBank did not have or maintain the systems or personnel necessary to
perform and generate the foregoing reports to assess the reliability of the Company's
financial derivatives activity . Moreover, had NetBank properly applied GAAP, i.e.,
correctly applied the traditionally more well recognized. and accepted regression
methodology, the Company risked the revelation that it had overly relied upon non-
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conforming mortgage loans to disguise weaknesses in its core banking segment.
203. By failing to comply with the requirements of FAS 133, NetBank failed
to qual ify for hedge accounting . This failure resulted in the Company publicly i ssuing
materially false and misleading financial statements for the periods covering fiscal
years 2004 and 2005. Although E&Y provided unqualified audit opinions for those
years, E&Y later refused to re-issue its 2004 and 2005 audit opinions for inclusion
in the 2006 Form 10-K until NetBank resolved the SEC's comments regarding the
Company ' s application of FAS 133 in accounting for the Company's mortgage
servicing rights and loans held for sale. The vast majority of previously reported net
income is a result of NctBank's improper hedge accounting.
204. In the prospectus, NetBank also claimed that "SFAS 133 is effective for
all fiscal quarters of fiscal years beginning after June 15, 1999." However, NetBank
claimed that "[t]he adoption of SFAS 133 is not expected to have a significant effect
on our financial statements."
205. It its 2005 Annual Report issued on or about March 15, 2006, NetBank
explained that:
NetBank's portfolio of derivatives which are designated and qualify ashedges are accounted for per the guidance set forth in SFAS 133, as
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amended. As such, the Company tests the fair value hedges related to its
mortgage loans held for sale and mortgage servicing rights at inception
and on an ongoing basis to determine that the derivatives are highly
effective in offsetting changes in fair values or cash flows of the
respective hedged items. Gains and losses on derivatives hedging
servicing assets are included in other income, and gains and losses on
derivatives hedging mortgage loans held for sale are included in gains
on sales of loans and mortgage servicing rights.
If a derivative fails to meet hedge effectiveness tests, if hedge
designation for a derivative is discontinued, or if the asset or liability
being hedged is disposed of, the derivative is marked-to-market through
the statement of operations and included in other income. The amount
ofhedge ineffectiveness was not material,fc)r the years 2005 and 2004.
Derivatives not designated as either fair value or cash flow hedges are
marked-to-market through the statement of operations and included in
gain (loss) on derivatives with the offsetting entry to other assets or
liabilities.
206. During the relevant period NetBank attempt to conceal its failure to
comply with SFAS 133 by lobbying the SEC to reduce disclosure obligation with
respect to its application. For example, NetBank provided comments to the SEC
regarding the disclosures required pursuant SFAS 133, which it claimed were "overly
burdensome." Discussing Netbank's arguments against additional disclosures under
SFAS 133, the SEC wrote:
Netbank Inc. summed up its arguments against additional disclosures by
stating, "If one of the intended benefits of the proposed accounting
standard is to provide companies relief from the documentation and
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paperwork requirements of FAS 133, the existence of paragraph (3)(e)
may very well put in place a documentation and paperwork requirement
that is equally onerous. In drafting the final rule under (3), we ask that
the FASB keep the documentation and disclosure requirements as
simple as possible."
207. On March 15, 2006, Defendants filed NetBank's Form 10-K for the
fiscal year ended December 31, 2005. That filing discussed NetBank's hedging
activities and application of FAS 133 under GAAP accounting, including inter a/ia:
The Company utilizes hedge accounting treatment for its servicing rights
under SFAS 133. If changes in. the value of the servicing rights and the
hedges meet certain hedge effectiveness criteria, changes in the fair
value of the servicing rights may be offset in the income statement by
changes in the fair value of the hedging instrument . Under SFAS 133,
as amended, the hedges are marked-to-market through the income
statement as other income.
208. On August 31, 2006, NetBank received an initial comment letter from
the SEC Staff regarding the Company's Form 10-K for the fiscal year ended
December 31, 2005 as filed on March 15, 2006.
209. The SEC' s comment letter questioned NetBank ' s application of
Financial Accounting Standards Board Statement of Financial Accounting Standards
No. 133, Accounting for Derivative Instruments and Hedging Activities ("SFAS
133"), to the accounting of its mortgage servicing rights and loans held for sale.
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Under SFAS 133, NetBank performed its hedge effectiveness assessments using a
statistical analysis approach other than regression. However, the SF..C questioned
whether NetBank's method of assessing hedge effectiveness was reasonable in the
circumstances and asked the Company to perform extensive supplemental analysis
to demonstrate the reasonableness ofNetBa.nk's method in comparison to a regression
methodology. Although NetBank was purporting to largely exit the lines of business
to which the SEC 's comment letters related , those lines formed a signi fi cant portion
of the Company's business in 2004 and 2005 which drove, in part , the value of the
Company at those times. The Individual Defendants knew that if the Company were
required to apply a different method of assessing hedge effectiveness it would
necessarily require a restatement of, at least, the Company's financial results as
audited by E&Y for the years 2004 and 2005 and could spell financial ruin for
NetBank. Notwithstanding the materiality of this information to investors, NetBank
failed to disclose these issues and allowed the investing public to continue to
purchase and hold the stock on the belief that the Company's prior financial results
were accurate.
210. Despite the severity of the potential consequences of the August 31,
2006, SEC letter and E&Y's reservations, NetBank did not reveal the existence ofthe
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SEC letter until almost one year later on July 18, 2007. Those revelations were made
long after NetBank had failed to file financial results for 2006 in the wake of E&Y's
continuing refusal to re-issue its audit report covering the consolidated financial
statements of the Company for the years ended December 31, 2004 and 2005, for
inclusion in the 2006 Form 10-K.
211. On July 18, 2007, NetBank filed a Form 8-K with the SEC, signed by
Defendant Gross, in which it revealed for the first time that for nearly a year it had
been under SEC scrutiny regarding its SFAS 133 accounting. Thus, in the Form 8-K,
NetBank revealed:
On August 31, 2006, we received an initial comment letter from the SEC
Staff regarding the Company's Annual Report on Form 10- K for the
fiscal year ended December 31, 2005 (the "2005 Form 10-K"), to which
the Company provided an initial response. Subsequently, the Company
received follow-up and additional comment letters from the SEC Staff
relating to the 2005 Form l0-K and the Company's Quarterly Reports
on Form 10-Q for the quarters ended March 31, 2006, June 30, 2006 and
September 30, 2006. The Company has provided responses to all
subsequent letters. However, as of the date of this Current Report on
Form 8-K, certain comments remain unresolved as the Company and the
SEC Staff continue to review and discuss the Company's application of
Financial Accounting Standards Board Statement of Financial
Accounting Standards No. 133, Accountingfbr Derivative Instruments
and Iledging Activities ("SFAS 133"), to the accounting of its mortgage
servicing rights and loans held for sale.
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212. In the same Form 8 -K, NetBank also revealed that E&Y had formally
advised the Company that it would not re-issue its audit report covering NetBank's
consolidated financial statements for the years ended December 3 l , 2004 and 2005,
for inclusion in the 2006 Form 10-K. E&Y also indicated that it would not re-issue
such audit report for inclusion in the 2006 Form 10-K until the Company has resolved
with the SEC, the SEC's comments with respect to the Company's application of
SFAS 133 to the accounting of mortgage servicing rights and loans held for sale.
213. A component of the E.&Y audit was the provisions of FAS 133 which
E&Y established for NetBank in 2002. Each year, over the several years, E&Y
changed their interpretation ofhow NetBank should comply with FAS 133, and each
time, required NetBank to conduct additional analysis of previous years' accounting
before E&Y would sign off on their full-year financials. The area in question
pertained to the effectiveness of NetBank's hedging against loans.
214. In 2006, E&Y said that NetBank had to re-calculate its loan hedge-
effectiveness on a daily analysis basis for the years 2005 and 2006, long after the
hedges were in place . As a result of the increasing demands by E&Y, in 2006,
NetBank CEO Steve Herbert exploded during a conference with the E&Y auditors
over why they wanted NetBank to change the way they complied with FAS 133 each
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year. As a result of this disagreement , among other things, E&Y withdrew as
NetBank's auditors..A.l though they had been paid for the full years' 2006 audit, E&Y
would not sign off on NetBank's 4" Quarter 2006 financials and would not provide
their sign off for the 2006 full-year audit.
X. THE TRUTH REGARDING DEFENDANTS' FRAUDBEGINS TO EMERGE
215. The fact that Defendants had significantly misrepresented NetBank's
financial results, operations and condition in order to defraud investors did not
become known on a single day. Rather, the truth about Defendants' fraud and
NetBank's true financial condition began to emerge on May 21, 2007, and continued
through the time of its ultimate demise, representing the largest bank failure in the
United States in 14 years and beyond. Because NetBank has not filed its audited
financial statements for 2006 and E&Y has refused to re-issue its 2004 and 2005
audit report, the true extent of the fraud remains unknown. Although the truth
regarding the Defendants' fraud began to emerge on May 21, 2007, the truth
regarding NetBank's deteriorating financial condition, which was a direct and
proximate result of Defendants' fraud, began prior to the end of the Class Period on
May 21, 2007. The truth regarding NetBank' s true financial condition emerged in a
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series of partial disclosures throughout the Class Period. For example, an aspect of
truth regarding NetBank's true condition, but not the truth of the Defendants' fraud,
was partially disclosed on November 9, 2006, when the Company revealed that Ernst
& Young had resigned as its auditor. Aspects of the truth about NetBank's financial
condition, but not the truth of the Defendants' fraud, were partially disclosed on
February 21, 2007, when the Company announced its preliminary unaudited results
for the year ended December 31, 2006, having recorded an after-tax loss of $86.3
million or $1.86 per share during the fourth quarter.
A. First Disclosure of Regulatory Issues
216. On May 21, 2007, NetBank issued a press release in which it announced
that it had been forced to sell. core assets, outside the context of the restructuring, in
order to cover its bank deposit obligations. Yet, these assets were the very assets that
NetBank's restructuring was intended to preserve. However, the sale was not
voluntary. Rather, as the Company disclosed for the first time, it had been compelled
by banking regulators who "advised" NetBank management to find an "alternative"
to the restructuring to shore up NetBank's "capital and earnings trends" "immediately
[to] cover all of the bank's deposit obligations."
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217. For the first time, NetBank's May 21, 2007, announcement
acknowledged that many of the problems it faced were not due to the "weakened
fundamentals of our core businesses." In effect, NetBank had thus revealed that its
efforts to enter new business segments by leveraging its core business was a failure
and that the initial appearance that that strategy had been positive was premised upon
the Company's false and misleading financial statements for the years 2004 and 2005
prepared by E&Y. Yet, even then, NetBank did not reveal that it had been under
intense scrutiny from the SEC. Rather, NetBank claimed only that it had been under
extreme financial pressure for more than a year mainly due to a difficult mortgage
origination market and a flat yield curve. The Company claimed that those pressures
resulted in large operating losses that significantly reduced the company's capital
position.
218. According to a confidential witness who was a senior executive officer
of NetBank during most of the Class Period, and who had direct daily contact with
the top executive officers, the Defendants were aware at least as early as the time
banking regulators became involved in the direction of the Company that ifNetBank
could not be sold, it would fail.
219. Despite the long overdue acknowledgment by NetBank on May 21,
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2007, according to a confidential witness who was a senior corporate officer of
NetBank during most of the Class Period, and who provided input directly to
defendants Freeman, Herbert, and Gross, as early as the third quarter of 2006, the
De.Cendants were aware that a sale ofthe entire Company was necessary. Accordingly,
NetBank and the Individual Defendants attempted to merge or sell NetBank at least
twice before the EverBank transaction was pursued. Specifically, in September, 2006,
NetBank held discussions with First Horizon which quickly failed once First Horizon
conducted its due diligence of NctBank.
220. Ultimately, in response to pressure from regulators, NetBank sold, at a
loss ofbettiveen $60 to $ 70 million : $2.5 billion of the Company's core and brokered
deposits; NetBank's held for investment loan portfolio; all ofthe assets and liabilities
ofNetBank Business Finance , the Company' s small business equipment leasing and
financing operation; and the NetBank brand and related trademarks and service
marks. In its May 21, 2007 press release, NetBank:
announced that the bank has executed an asset purchase and liability
assumption agreement with EverBank, an FDIC-insured, federal savings
bank and subsidiary of EverBank Financial Corp., a privately held
financial services holding company headquartered in Jacksonville, Fla.,
with approximately $4.7 billion in assets. The purchase price represents
a discount to the current carrying value ofthe assets and liabilities being
conveyed, and NetBank anticipates recording a loss on sale of between
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$60 and $70 million at close.
The transaction is expected to close by the end of June 2007, subject to
regulatory approval, and relates to the broader initiative the company
began earlier in the year to consider strategic alternatives that would
allow management to serve the interests of its customers, while
protecting the company's equity position from continued erosion.. The
company has been under extreme financial pressure for more than a year
due to a difficult mortgage origination market, a flat yield curve
environment and other factors. These pressures have resulted in large
operating losses that have significantly reduced the company's capital.
position and prompted heightened regulatory oversight.
NctBank worked closely with regulators as it evaluated various
opportunities. Regulators have been increasingly concerned about the
bank's capital and earnings trends and advised management to find an
alternative immediately that covered all of the bank's deposit
obligations.
The primary assets and liabilities in the transaction include:
The bank's held for investment loan portfolio;
* All of the assets and liabilities of NetBank Business Finance, the
bank's small business equipment leasing and financing operation;
* The bank's $2.5 billion in core and brokered deposits; and
* The NetBank brand and related trademarks and service marks.
Management Commentary
"In spite of our best efforts to improve the company's operating profile
through the restructuring plan we undertook last year, our company has
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remained very vulnerable and at risk due to the weakened,fundamentals
ofour core businesses," said Steven F. Herbert, chief executive officer,
NetBank, Inc. "Our mortgage operations continue to struggle in the face
of a highly competitive marketplace, especially the third-party
origination channel. Bank earnings have also fallen sharply as we have
had to de-leverage the balance sheet in order to maintain risk-based
capital ratios within appropriate regulatory guidelines.
"Our effort to manage and address these pressures was further
complicated by the delay of the annual audit and greater day-to-day
regulatory oversight and involvement.
"Our remaining businesses will include our mortgage servicing
operation, along with our retail prime mortgage franchise, Market Street
Mortgage," Herbert concluded. "We are actively evaluating their long-
term strategic alternatives as well as those of the parent company as a
whole. We have also retained our CMC claim. and the deferred tax asset
that we generated in the fourth quarter of 2006. After consummation of
the EverBank transaction, we will focus intensely on prosecuting the
CMC sureties and pursuing our claim against them, which we now
estimate at $150 million."
221. On May 21, 2007, defendants Herbert and Gross held a conference call
with analysts to discuss the Company's shocking revelations. On the call, Defendant
Herbert stated that "We sought and were unable to successfully pursue a transaction
for the entire company." He further explained that, "In the end, EverBank was the
only partner that stepped up with a plan that the regulators were prepared to seriously
consider." Herbert stated that after transitioning the deposit base to EverBank, the
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residual portions of the bank platform would need to be shut down at a cost of $26
million to $34 million. On the call Herbert also estimated that shareholders equity
dropped to $182 million from $229 million at the end of 2006. He forecast
shareholder equity would further decline to $50 million to $70 million after costs to
unwind the businesses that were being shut down or sold.
222. In response to this disastrous news, the market , shocked, reacted sharply
and swiftly. NetBank's stock price plummeted from $1.75 per share on Friday, May
18, 2007 to $0.59 per share on May 21, 2007 (the next trading day), a drop in price
of over 66% on massive volume of 1 1,190,400, which was over forty-five times the
volume of the previous trading day.
223. Undeterred , Herbert continued the charade that the failure to timely file
with the SEC was merely a "delay" rather than a substantive problem that threatened
the very continuation ofNctBank as a going concern and omitted that the Company's
accounting was under intense scrutiny from the SEC. Herbert stated:
Our effort to manage and address these pressures was
further complicated by the delay of the annual audit and
greater day-to-day regulatory oversight and involvement.
224. Herbert's statement remained materially false and misleading in that it
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falsely led investors to believe that the delay in filing the 2006 Form 10-K and First
Quarter 2007 Form I 0-Q was not due to a substantive issue , but rather was merely
the procedural result of not being able to engage an auditor in time to file. These
statements omitted to state that, in fact, the reason for the failure to timely file was the
failure of Defendants to comply with GAAP in valuing its core mortgage portfolio
and, through that, its tangible book value. Herbert's statements also omitted that the
Company was under intense scrutiny from the SEC regarding its FAS 133 accounting,
as alleged.
225. On May 22, 2007, as reported by the Associated Press, Paul J. Miller Jr,
an analyst with Friedman, Billings, Ramsey, said the net value of NetBank's assets,
which the bank then estimated at $25 million to $45 million, was "careening toward
zero." Based on the Company ' s May 21 , 2007 disclosure , Miller downgraded
NetBank to "Underperform" from "Market Perform" and cut his price target for
NetBank's common stock from $2.00 to $0.00. Analyst Christopher Marinac ofFIG
Partners LLC in Atlanta, dropped all coverage of NetBank as of that day.
226. In response to Miller's rating and the related news article, NetBank's
stock price fell a further 37%, from $0.59 per share on May 21, 2007 to $0.37 per
share on May 22, 2007.
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227. According to a confidential witness who was a NetBank officer
employed in the Corporate Fi Hance Department throughout the Class Period, and who
had direct dealings with top management including CFE Herbert, Defendants knew
that given NetBank's assets and liabilities the Company "could never close the
[F.verBan.k.] deal."
228. In addition to the fact that the Defendants independently knew that the
EverBank merger would not close based on the economic merits, Herbert also knew
that the transaction required approval by the OTS. However, at the time of Herbert's
May 21, 2007 statements, the work necessary to conduct the merger had not yet
begun. According to a confidential witness who was a senior corporate officer of
NetBank during most of the Class Period, and who provided input directly to
defendants Freeman, Ilerbert, and Gross, even as of June 2007 the parties were still
attempting to hire project leaders for the merger. According to that confidential
witness, the merger process had not begun because the parties lacked the necessary
personnel to complete the project.
229. On the May 21, 2007 conference call, defendant Herbert effectively
conceded that a sale of the entire Company was not a viable option because of the
status of the audit and lack of financials, and that simply delaying any sale was also
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not an option:
The OTS directed us to secure an immediate solution that enabled the
bank to meet all of those deposit obligations. I think they made it pretty
clear that if we did not soon resolve all the deposits , they would be
obligated to step in. And I think they also made it pretty clear that they
would not hesitate or delay to step in if needed.
So, we were unable to effectively pursue a transaction fi r the entire
company due to the status ofour annual audit. As you well know, we
don't have current financials and we couldn't secure a shareholder vote
because of the non-current nature of our financial statements.
So we were limited to fewer options and given the regulatory framework
that I just mentioned, waiting was not an option. Delay, we believed,
would have resulted in further capital erosion and probably or would
have brought to bear adverse regulatory actions.
230. Similarly, according to a confidential witness, who was a senior
executive of NetBank during the entire Class Period, and who had regular daily
interaction with defendants Freeman, Herbert and Gross, it was well known to
NetBank's management in March of 2007, that the Company would not survive.
Indeed, it was known and understood by the Defendants that the agreement reached
with EverBank would only provide sufficient capital to enable NetBank to shut down,
not to continue operations as Herbert claimed on the May 21, 2007 conference call.
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B. August 2007 Disclosure of Material Overvaluation
231. Long after NetBank's shocking revelations ofMay 21, 2007, additional
aspects of the truth continued to emerge; however, the damage was done and none
resulted in a material decline in the Company's stock price.
232. On August 6, 2007, NetBank filed a Form 8-K with the SEC in which
Defendants disclosed for the first time that one of the Company's core operations,
Market Street, NetBank's wholly-owned retail mortgage business, was not only
substantially overvalued in violation of GAAP, but was in fact worthless. As a result,
the Company took a non-cash impairment charge of approximately $24.6 million for
the impairment of goodwill assigned to Market Street where the carrying value of
Market Street was exactly the amount written off -- $24.6 million.
233. In the August 6, 2007 8-K, NetBank revealed that Market Street was
worthless and that its goodwill was impaired, a fact that Defendants claimed only to
have discovered when examining options to dispose of that entity:
Based on the information the Company obtained during the course of its
consideration of such other opportunities for Market Street, and the
likelihood of execution of one or more of such other opportunities, the
Company determined that an event indicative of impairment had
occurred with respect to Market Street.
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As a result, the Company evaluated the carrying value of goodwill of
Market Street, and on August 2, 2007, authorized officers of the
Company concluded that a material impairment charge with respect to
the carrying value of goodwill assigned to Market Street is required
under GAAP. As a result, for the second quarter ending Tune 30, 2007,
the Company expects to record a non-cash impairment charge of
approximately $24.6 million (both pre-tax and after tax) for the
impairment of goodwill assigned to Market Street.
234. Ina Form 8-K filed on August 6, 2007, NetBank also disclosed that the
Office of Thrift Supervision ("OTS") had notified NetBank that it was
undercapitalized and was required to respond with a capital restoration plan no later
than September 13, 2007 that would satisfy applicable regulations . NetBank also
confinned that its stock had no value and was a "highly speculative" investment:
Due to NetBank's capital category and as provided in the Notice,
NetBank is subject to various restrictions, including limits on (i) capital
distributions; (ii) growth in total assets; (iii) acquisitions of new
companies or offices; (iv) engaging in any new lines of business; and
(iv) accepting, renewing or rolling over of brokered deposits.
As aresult ofthe Company's obligations under the Notice, the Companybelieves that its outstanding common stock may have little or no value.Accordingly, investment in the Company's common stock would behighly speculative.
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235. As ofAugust 7, 2007, having confrm.ed what many investors recognized
as a result of NetBank ' s shocking revelations on May 21 , 2007 - that NetBank's
outstanding common stock had little or no value and that any investment in the stock.
would be highly speculative - the jig was finally up. Indeed, NetBank's August 6,
2007 Form 8-K also disclosed that the NASDAQ, likely recognizing NetBank's
assurances that it would ultimately file its long awaited financial reports [or the farce
that they were, intended to delist the Company's common stock due to its continued
failure to file its 2006 Form 10-K, which NetBank had promised the investing public
as of June 30, 2007, and the First Quarter 2007 Form 10-Q. After NetBank's
purported June 30, 2007 target date passed, its August 6, 2007 Form 8-K was the final
confirmation that the Company could no longer continue the charade and that its late
filings were, in fact, the result of the Defendants ' failure to properly vat ue NetBank's
core businesses in accordance with GAAP.
236. On August 7, 2007, NetBank reiterated that despite the fact that it
expected to receive $19.25 million from the settlement oflong standing litigation, the
Company reiterated its August 6, 2007 warning that Netbank common stock was
worthless.
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237. On this news, NetBank's stock price doubled from $0.06 per share on
August 22, 2007 (on volume of 34,089 shares) to $0.12 per share on August 23, 2007
(on astounding volume of 6,294,574 shares).
238. The statements set forth in the above subsection were materially false
and misleading because, in combination with the proposed sale of assets to EverBank,
this cash infusion falsely led investors to believe that the Company could now be in
compliance with OTS requirements.
C. The Disclosure of the Collapsed Everbank Agreement
239. On September 17, 2007, EverBank issued a press release in which it
announced: "that it ha[d] terminated its agreement to acquire NetBank's consumer
deposit accounts, business finance division and other assets under the transaction
announced on May 21, 2007, This decision comes after it became clear that NetBank
would not be able to complete certain conditions required to close and receive
regulatory approval."
240. NetBank's September 17, 2007 Form 8-K filed with the SEC announcing
the termination of the agreement stated that:
On September 14, 2007, the Bank received a letter from EverBank
notifying the Bank of EverBank's termination of the Purchase
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Agreement effective on September 14, 2007. EverBank's letter states
that NetBank is in breach of its representations and warranties as the
basis for its termination of the Purchase Agreement.
EverBank has not advised the Bank or the Company of any specifics
regarding the alleged breach. The Company and the Bank do not believe
that any breach has occurred. However, since the required regulatory
approvals were not received by August 3I, 2007, and since the Purchase
Agreement permits either party to terminate the Purchase Agreement
without cause after that date, neither the Company nor the Bank
presently contemplate contesting the termination. Instead the Company
intends to pursue such other strategic alternatives as may be available.
As a result of ongoing Financial and regulatory pressure, the Company
believes that its outstanding common stock may have little or no value.
Accordingly, investment in the Company' s common stock would be
highly speculative.
241. On September 28, 2007, NetBank, Inc. filed a voluntary petition for
relief under Chapter 1 I of the United States Bankruptcy Code in the United States
Bankruptcy Court for the Middle District of Florida, Jacksonville Division. The
Company announced that it would continue to operate as a debtor-in-possession
under the jurisdiction ofthe Bankruptcy Court. NetBank's failure represented the first
bank failure in five years, the largest ever in the State of Georgia and the largest in
the preceding 14 years.
242. On September 28, 2007, NetBank also announced that the Office of
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Thrift Supervision exercised its authority under applicable federal law to appoint the
Federal Deposit Insurance Corporation as receiver for NetBank, a federal savings
bank and a wholly-owned subsidiary of the Company.
243. In a September 28, 2007, press release, the OTS explained that:
The Office of Thrift Supervision (OTS) announced today that it closed
$2.5 billion NetBank, headquartered in Alpharetta, Georgia, and
appointed the Federal Deposit Insurance Corporation (FDIC) as
receiver.
A`etBank sustained significant losses in 2006 primarily due to early
payment defbulis on loans sold, weak underwriting, poor
documentation , a lack ofproper controls, and failed business strategies.
As a result, the OTS executed a formal enforcement action with
NetBank in 2006 directing the institution to correct its operating
deficiencies and enhance its capital position . While the institution
continued to operate in excess ofminimum capital standards , the actions
taken to address these problems were unsuccessful and it became clear
that high operating expenses combined with continuing losses were
jeopardizing the institution ' s viability.
In response, NetBank's board of directors undertook efforts to complete
a private sale of the institution. These efforts were unsuccessful and the
institution had no remaining prospects for raising capital and achieving
profitability. Accordingly, the OTS exercised its authority under the
Home Owners' Loan Act to appoint the FDIC as receiver of the
institution.
244. That same day, Eula L. Adams resigned as a member of the Board of
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Directors, of the Company. Mr. Adams' resignation was reportedly "not due to any
disagreement with the Company." Adams also resigned as a member of the Audit
Committee and Corporate Governance Committee of the Board effective September
28, 2007.
245. On October 1, 2007, EverBank announced that it successfully acquired
approximately $700 million of NetBank mortgage assets.
XX.. GAAP VIOLATIONS
246. As described above, the Defendants caused the Company to falsely
report its financial position and results of operations throughout the Class Period by,
among other things, overstating net earnings (or understating net losses, as
applicable) and misrepresenting the Company's true financial position. The
Company's 2004 and 2005 annual financial statements and. 2006 interim financial
statements for the first, second and third quarterly periods (collectively, the "relevant
financial statements") were not a fair presentation of the Company's financial
position and results of operations , and were not presented in conformity with GAAP
and SEC rules.
247. Generally Accepted Accounting Principles ("GAAP") are those
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principles recognized by the accounting profession as the conventions, rules, and
procedures necessary to define accepted accounting practices at a particular time.
GAAP principles are the official standards accepted by the SEC and promulgated in
part by the American Institute of Certified Public Accountants ("AICPA"). GAAP
consists of a hierarchy of authoritative literature . The highest priority is comprised
of Financial Accounting Standards Board ("FASB") Statements of Financial
.Accounting Standards ("FAS"), followed by FASB Interpretations ("FIN"),
Accounting Principles Board Opinions ("APB"), and AICPA Accounting Research
Bulletins ("ARB"). GAAP provides other authoritative pronouncements including,
among others , the FASB Concept Statements ("FASCON").
248. As a publicly traded company during the Class Period, NetBank was
responsible for and required to maintain books and records in sufficient detail to
reflect the transactions of the Company and, therefore, prepare financial statements
in accordance with GAAP. Specifically , the Exchange Act, 15 U.S.C. § 78m (b) (2),
requires public companies to:
(A) make and keep books, records, and accounts, which, in reasonabledetail, accurately and fairly reflect the transactions and dispositions ofthe assets of the issuer; and
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(B) devise and maintain a system of internal accounting controlssufficient to provide reasonable assurances that -
transactions are executed in accordance with
management's general or specific authorization;
H. transactions are recorded as necessary to permit
preparation of financial statements in conformity with
generally accepted accounting principles or any other
criteria applicable to such statements, and
iii. to maintain accountability for assets;
iv. access to assets is permitted only in accordance with
management's general or specific authorization; and
V. the recorded accountability for assets is compared with the
existing assets at reasonable intervals and appropriate
action is taken with respect to any differences.
249. SEC Regulation S-X (17 C.F.R. § 210.4-01(a)(1)) states that financial
statements filed with the SEC which are not prepared in compliance with GAAP are
presumed to be misleading and inaccurate, despite footnote or other disclosure.
Regulation S-X requires that interim financial statements must also comply with
GAAP, with the exception that interim financial statements need not include
disclosure which would be duplicative of disclosures accompanying annual financial
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statements . (17 C.F.R. § 210.10-01(a)).
A. Lack of Ade uate Internal Controls
250. Despite repeated certifications and other public statements by
Defendants as alleged more fully herein, NetBank lacked effective disclosure controls
and procedures, and internal control over financial reporting. Absent proper controls
and procedures, the resulting Financial reporting may be materially false and
misleading . Indeed, NetBank's lack of adequate controls was so profound and
irreconcilable, the Company's independent auditor, E&Y, resigned effectively in
protest over this issue in. November 2006.
251. NetBank's 2004 Form 10-K, filed with the SEC on March 16, 2005 --
the opening ofthe alleged Class Period, reported that the Company's internal controls
had been found to be deficient, but assured investors that such deficiencies had been
corrected and would not recur:
Management's Conclusion on the Effectiveness of Disclosure
Controls and Procedures
The Company's Chief Executive Officer and Chief Financial Officer,along with other management of the Company, reviewed and evaluatedthe Company's disclosure controls and procedures (as defined in rule13a-15(e) under the Securities Exchange Act of 1934, as amended (the
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"Exchange Act")) as of December 31, 2004. Based on that evaluation,
the Chief Executive Officer and Chief Financial Officer ofthe Company
concluded that, as of December 31, 2004, the disclosure controls and
procedures in place at the Company were not effective due to a material
weakness in its internal control over financial reporting related to the
estimation of the change in fair value of the Company's portfolio of
mortgage loan funding commitments for which the interest rate is locked
("rate locks") which constitute derivative financial instruments as
defined by Statement of Financial Accounting Standards No. 133
("SFAS 133"), Accounting for Derivative Instruments and Hedging
Activities, as amended by Statement ofFinancial Accounting Standards
No. 149 ("SFAS 149"), Amendment of Statement 133 on Derivative
Instruments and Hedging Activities. The error would have resulted in an
overstatement ofthe mark-to-market ofthe derivatives which is included
in the gain on sale line item.
Due to this material weakness, the Company, in preparing its financial
statements at and for the year ended December 3 t, 2004, performed and
implemented the additional procedures discussed below under the
heading "Other Control Matters" to strengthen its controls and
procedures over the process. Due to the nature ofthe material weakness
and the additional procedures implemented, management believes the
circumstances which resulted in the error will not recur.
252. In that same 2004 Form 10-K, Defendants admitted their responsibility
for the Company's financial internal controls and further explained:
Management's Annual Report on Internal Control over Financial
Reporting
The management of NetBank is responsible for establishing andmaintaining adequate internal control over financial reporting (as
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defined in Rule 13a-15(f) under the Exchange Act). NctBank's internal
control system is designed to provide reasonable assurance to the
Company's management and Board of Directors regarding the
preparation and fair presentation of published financial statements.
An internal control material weakness is a significant deficiency, or
aggregation of deficiencies, that does not reduce to a relatively low level
the risk that material misstatements in financial statements will be
prevented or detected on a timely basis by employees in the normal
course of their work. An internal control signilcant deficiency, or
aggregation of deficiencies, is one that could result in a misstatement of
the fnancial statements that is more than inconsequential.
The management of NetBank assessed the effectiveness of the
Company's internal control over financial reporting as ofDecember 31,
2004, and this assessment identified a material weakness in the
Company's internal control over financial reporting related to its
controls over the determination and estimation of the change in fair
value of the Company's portfolio of mortgage loan funding
commitments where the interest rate has been locked and related
financial derivatives. Changes in such fair value are recorded to gain on
sales of loans and to other assets or other liabilities. As a result of this
material weakness, the Company had overstated its gain on sales of
loans and recorded an adjustment in the December 31, 2004 financial
statements to correct this error.
In making its assessment of internal control over financial reporting
management used the criteria issued by the Committee of Sponsoring
Organizations of the Treadway Commission (COSO) in Internal
Control-Integrated Framework. Because of the material weakness
described in the preceding paragraph, management believes that, as of
December 31, 2004, the Company's internal control over financial
reporting was not effective based on those criteria.
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253. In that same 2004 Form 10-K, Defendants included a letter dated March
11, 2005 from NetBank's independent auditor, E&Y to the NetBank Board and the
Company's shareholders, which stated in pertinent part:
Report of Independent Registered Public Accounting Firm on
Internal Control over Financial Reporting
The Board of Directors and Shareholders of NetBank, Inc.
We have audited management's assessment, included in the
accompanying Management's Annual Report on Internal Control over
Financial Reporting, that NetBank, Inc. did not maintain effective
internal control over financial reporting as of December 31, 2004,
because of the effect of a material error that was not identified by
NetBank, Inc.'s internal control over financial reporting, based on
criteria established in Internal Control----Integrated Framework issued
by the Committee of Sponsoring Organizations of the Treadway
Commission (the COSO criteria). NetBank, Inc.'s management is
responsible for maintaining effective internal control over financial
reporting and for its assessment of the effectiveness of internal control
over financial reporting. Our responsibility is to express an opinion on
management's assessment and. an opinion on the effectiveness of
NetBank, Inc.'s internal control over financial reporting based on our
audit.
We conducted our audit in accordance with the standards of the Public
Company Accounting Oversight Board (United States). Those standards
require that we plan and perform the audit to obtain reasonable
assurance about whether effective internal control over financial
reporting was maintained in all material respects. Our audit included
obtaining an understanding of internal control over financial reporting,
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evaluating management's assessment, testing and evaluating the design
and operating effectiveness of internal control, and performing such
other procedures as we considered necessary in the circumstances. We
believe that our audit provides a reasonable basis for our opinion.
A company's internal control over financial reporting is a process
designed to provide reasonable assurance regarding the reliability of
financial reporting and the preparation of financial statements for
external purposes in accordance with generally accepted accounting
principles.
A company's internal control over financial reporting includes those
policies and procedures that (l) pertain to the maintenance of records
that, in reasonable detail, accurately and fairly reflect the transactions
and dispositions of the assets of the company; (2) provide reasonable
assurance that transactions are recorded as necessary to permit
preparation of financial statements in accordance with generally
accepted accounting principles, and that receipts and expenditures o Fthe
company are being made only in accordance with authorizations of
management and directors of the company; and (3) provide reasonable
assurance regarding prevention or timely detection of unauthorized
acquisition, use, or disposition of the company's assets that could have
a material effect on the financial statements.
A material weakness is a control deficiency, or combination of controldeficiencies, that results in more than a remote likelihood that a materialmisstatement of the annual or interim financial statements will not beprevented or detected. The following material weakness has beenidentified and included in management's assessment. There wereinsufficient controls over the determination and estimation ofthe changein fair value of the Company"s portfolio of mortgage loan fundingcommitments where the interest rate has been locked and the relatedfinancial derivatives. As a result of this material weakness in internal
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control, NctBank, Inc. concluded that the amount of gain on sales ofloans was overstated and recorded an adjustrn.ent to correct this error.This material weakness was considered in determining the nature,timing, and extent of audit tests applied in our audit of the 2004financial statements, and this report does not affect our report datedMarch 11, 2005 on those financial statements.
In. our opinion, management's assessment that NetBank, Inc. did not
maintain effective internal control over financial reporting as of
December 31, 2004 is fairly stated, in all material respects, based on the
COSO control criteria. Also, in our opinion, because of the effect of the
material weakness described above on the achievement of the objectives
of the control criteria, NetBank, Inc. has not maintained effective
internal control over financial reporting as of December 31, 2004 based
on the COSO control criteria.
254. In that same 2004 Form 10-K, Defendants also included a response as
to the identified material control weakness and provided these additional assurances
to investors:
In response to the material control weakness discussed above in
Management's Annual Report on Internal Control over Financial
Reporting, management has taken the following steps to remediate the
control weakness:
• The necessary data and information for estimating the initial and
ending fair values are now accumulated within a single
department;
• Analytics are now being prepared which compare the changes in
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fair value to changes in the fair value of offsetting hedges andgeneral changes in interest rates to ensure results are reasonable;
The Company's corporate controller is now required to review the
process and associated analysis.
Management will continue to closely monitor the changes implemented
to ensure their effectiveness. Except for the changes discussed above,
there were no other changes in the Company's internal control over
financial reporting that have materially effected, or are reasonably likely
to materially effect, its internal control over financial reporting.
255. Similarly, the Company's Forms 10-Q for the first, second and third
fiscal quarters of 2005 (filed with the SEC on May 10, August 9 and November 14,
2005, respectively ) repeated Defendants " assurances that the Company' s controls
were operating effectively. In addition , each of those financial reports purported to
report the Company's financial condition as of the end ofthe respective fiscal quarter
and financial results for the fiscal quarter.
256. NetBank's 2005 Form 10-K, filed with the SEC on March 15, 2006 again
reported that the Company's internal controls had been found to be effective:
Management's Conclusion on the Effectiveness of Disclosure
Controls and Procedures
Evaluation of Disclosure Controls and Procedures. We evaluated the
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effectiveness of the design and operation of our "di.sclosure controls andprocedures," as defined in Rule 13a-15(e) under the Securities Exchange
Act of 1934, as amended (the "Exchange Act"), as of the end of theperiod covered by this report. This evaluation was done under thesupervision and with the participation of management, including ourchief executive ofl:icer ("CEO") and chief finance executive ("CFO").
x;E ;r^C
Objectives ofControls. Disclosure controls and procedures are designed
so that infonnation required to be disclosed in our reports filed under the
Exchange Act, such as this Annual Report on Form 10-K, is recorded,
processed, summarized and reported within the time periods specified
in the SEC's rules and forms. Disclosure controls and procedures are
also intended to ensure that such information is accumulated and
communicated to our management, including the CEO and CFO, as
appropriate to allow timely decisions regarding required disclosure.
Conclusions. Based upon the disclosure controls and procedures
evaluation, our CEO and CFO have concluded that as of December 31,
2005, our disclosure controls and procedures are effective to provide
reasonable assurance that the foregoing objectives are achieved.
Changes in internal Control over Financial Reporting. There were no
changes in our internal control over Financial reporting, as defined in
Rule 13a-15(t) under the Exchange Act, during the quarter ended
December 31, 2005 that have materially affected, or are reasonably
likely to materially affect, our internal control over financial reporting.
257. In that same 2004 Fonn 10-K, Defendants admitted their responsibility
for the Company's financial internal controls and further explained:
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Management's Annual Report on Internal Control over Financial
Reporting
The management of NetBank is responsible for establishing and
maintaining adequate internal control over financial reporting as such
term is defined in Rule 13a-15(f) under the Exchange Act. Our internal
control over financial reporting is a process designed to provide
reasonable assurance regarding the reliability of financial reporting and
the preparation of financial statements for external purposes in
accordance with accounting principles generally accepted in the United
States of America.
Management, under the supervision and with participation of the CEOand CFO, has assessed the effectiveness of the Company's internal
control over financial reporting as ofDecember 31, 2005. In making this
assessment, management used the criteria set forth by the Committee ofSponsoring Organizations of the Treadway Commission (COSO) in
Internal Control-Integrated Framework. Based on management's
assessment and that criteria, management concludes that, as of
December 3 1, 2005, the Company's internal control over financial
reporting is effective.
258. In that same 2005 Form 10-K, Defendants included a letter dated March
13, 2006 from NetBank's independent auditor, E&Y to the NetBank Board and the
Company's shareholders, which stated in pertinent part:
Report of Independent Registered Public Accounting Firm on
Internal Control over Financial Reporting
The Board of Directors and Shareholders of NetBank, Inc.
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We have audited management's assessment, included in the
accompanying Management's.Annual Report on Internal Control over
Financial Reporting, that NetBank, Inc. maintained effective internal
control over financial reporting as of December 3 I , 2005, based on
criteria established in Internal Control-Integrated Framework issued
by the Committee of Sponsoring Organizations of the Treadway
Commission (the COSO criteria). NetBank, Inc.'s management is
responsible for maintaining effective internal control over financial
reporting and for its assessment of the effectiveness of internal control
over financial reporting. Our responsibility is to express an opinion on
management's assessment and an opinion on the effectiveness of the
company's internal control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public
Company Accounting Oversight Board (United States). Those standards
require that we plan and perform the audit to obtain reasonable
assurance about whether effective internal control over financial
reporting was maintained in all material respects. Our audit included
obtaining an understanding of internal control over financial reporting,
evaluating management's assessment, testing and evaluating the design
and operating effectiveness of internal control, and performing such
other procedures as we considered necessary in the circumstances. We
believe that our audit provides a reasonable basis for our opinion.
A company's internal control over financial reporting is a process
designed. to provide reasonable assurance regarding the reliability of
financial reporting and the preparation of financial statements for
external purposes in accordance with generally accepted accounting
principles. A company's internal control over financial reporting
includes those policies and procedures that (1) pertain to the
maintenance of records that, in reasonable detail, accurately and fairly
reflect the transactions and dispositions ofthe assets of the company; (2)
provide reasonable assurance that transactions are recorded as necessary
to permit preparation of financial statements in accordance with
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generally accepted accounting principles, and that receipts and
expenditures of the company are being made only in accordance with
authorizations of management and directors of the company; and (3)
provide reasonable assurance regarding prevention or timely detection
ofunauthorized acquisition, use, or disposition of the company's assets
that could have a material effect on the financial statements.
Tn our opinion, management's assessment that NetBank, Tnc. maintained
effective internal control over financial reporting as of December 31,
2005, is fairly stated, in all material respects, based on the COSO
criteria. Also, in our opinion, NetBank, Inc. maintained, in all material
respects, effective internal control over financial reporting as of
December 31, 2005, based on the COSO criteria.
We also have audited, in accordance with the standards of the Public
Company Accounting Oversight Board (United States), the consolidated
balance sheets ofNetBank, Inc. as of December 31, 2005 and 2004, and
the related consolidated statements of operations, shareholders' equity,
and cash flows for each of the three years in the period ended December
31, 2005 and our report dated March 13, 2006 expressed an unqualified
opinion thereon.
259. On April 10, 2006, NetBank issued a press release via Business Wire
which stated in pertinent part that the Company:
[NetBank] is currently implementing the FRS RiskResolve solution as
the foundation of its Sarhanes-Oxley (SOX) compliance strategy. The
diversified financial services provider will utilize RiskResolve to
automate SOX testing and attestation in a single application in order to
streamline its compliance efforts and achieve greater transparency across
the enterprise. NetBank will also extend its use of the FRS solution
beyond compliance to enterprise operational risk management (EORM)
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during the next phased deployment of RiskResolve to the business unit
owners. Risk.R.esolve`s automated COSO approach will enableNetBank
to align risk assessments, controls and actions to its reporting procedures
throughout the organization and establish compliance and operational
risk management as sustainable business processes.
"The RiskResolve deployment is an important element of our on-going
SOX compliance strategy," said Joyce Bellows, Director of SOX and
Internal Controls, NetBank, Inc. "We believe that the solution is
uniquely qualified to give us unprecedented insight into our business
processes and risk scenarios, and to help ensure that our financial
reporting and disclosures are accurate and complete."
260. Similarly, the Company's Forms 10-Q for the first, second and third
fiscal quarters of 2006 (filed with the SEC on May 10, August 8 and November 9,
2006, respectively) repeated Defendants' assurances that the Company's controls
were operating effectively. In addition, each of those financial. reports purported to
report the Company's financial condition as ofthe end ofthe respective fiscal quarter
and financial results for the fiscal quarter.
261. E&Y's resignation as NetBank's independent auditor became effective
on November 9, 2006. Despite the representations of NetBank and E&Y, the
Company had a significant ongoing disagreement with NetBank regarding the
calculation of the Company's hedge effectiveness under FAS 133. Acknowledging
the weakness in its internal controls, NetBank revealed that E&Y had resigned, at
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least in part, because of the "the determination. and estimation of the change in fair
value of the Company's portfolio of mortgage loan funding commitments where the
interest rate had been locked ." NetBank also reported that (emphasis added): "[i]n
2005, the Company implemented certain changes to its internal controls to address
the material weakness over the Company's rate locks and determined that the
material weakness existing at December 31, 2004 was corrected."
262. NetBank's Form 8-K, filed November 9, 2006, which reported the
resignation of E&Y as the Company's auditor, also reported:
In the Company's Annual Report on Form 10-K for the fiscal year ended
December 31, 2004, which the Company Filed with the SEC on March
16, 2005, Management's Annual Report on Internal Control over
Financial Reporting stated, and E&Y's report on internal controls
reiterated, that because of the material weakness disclosed in those
reports, the Company's internal control over Financial reporting was not
effective as of December 31, 2004, based on the criteria set forth by the
Committee of Sponsoring Organizations of the Treadway Commission
in Internal Control - Integrated Framework. The material weakness in
those reports concerned the Company's controls over the determination
and estimation of the change in fair value ofthe Company's portfolio of
mortgage loan funding commitments where the interest rate had been
locked and the related financial derivatives ("rate locks"). In 2005, the
Company implemented certain changes to its internal controls to address
the material weakness over the Company's rate locks and determined
that the material weakness existing at December 31, 2004 was corrected.
263. On February 21, 2007, NetBank issued a press release via Business Wire,
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in which it claimed that:
The company currently believes that the 2006 audit, and related auditor
attestation regarding the company's internal control over financial
reporting, will be completed in June 2007 and expects to file its Annual
Report on Form l 0-K for the 2006 fiscal year with the SEC on or before
June 30, 2007, although no assurance can be given.
264. On March 23, 2007, NetBank issued a press release via Business Wire,
in which it repeated certain statements regarding its internal controls contained in a
press release issued by the Company on February 21, 2007, reporting in pertinent part
that:
The company currently believes that the 2006 audit, and related auditor
attestation. regarding the company's internal control over financial
reporting, will be completed in June 2007 and expects to file its 10-K
with the SEC on or before June 30, 2007, although no assurance can be
given.
265. E&Y' s sentiments were echoed by the SEC. On July 17, 2007, NetBank
revealed that beginning nearly a year earlier, on August 31, 2006, the Company had
begun to receive a series of letters from the SEC challenging the Company's
application of Financial Accounting Standards Board Statement of Financial
Accounting Standards No. 133, Accountingfor Derivative Instru ments and Hedging
Activities ("FAS 133"), to the accounting of its mortgage servicing rights and loans
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held for sale. Specifically, NetBank revealed for the first time that nearly a year
earlier:
On August 31, 2006, we received an initial comment letter from the SEC'
Staff regarding the Company's Annual Report on Form 10- K for the
fiscal year ended December 31, 2005 (the "2005 Form 10-K"), to which
the Company provided an initial response. Subsequently, the Company
received follow-up and additional comment letters from the SEC Staff
relating to the 2005 Form I 0-K and the Company's Quarterly Reports
on Form 10-Q for the quarters ended March 3 1, 2006, June 30, 2006 and
September 30, 2006. The Company has provided responses to all
subsequent letters. However, as of the date of this Current Report on
Form s-K, certain comments remain unresolved as the Company and the
SEC Staff continue to review and. discuss the Company's application of
Financial Accounting Standards Board Statement of Financial
Accounting Standards No. 133, Accounningfor Derivative Instruments
and.HedgingActi vities ("SFAS 133"), to the accounting of its mortgage
servicing rights and loans held for sale.
266. E&Y refused to re-issue its audit opinion for inclusion in NetBank's
2006 Form 10-K until the Company resolved the SEC's issues with respect to the
Company's application oIFAS 133 related to the accounting of mortgage servicing
rights and loans held for sale. E&Y's refusal likely prompted NetBank's July 17,
2007 revelations. More that one year later, at the time of its collapse on September
28, 2007, NetBank still had not - nor has it ever -- resolved the SEC's issues or filed
audited financial results for 2006.
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267. On September 27, 2007, The Wall Street Journal reported that the
collapse of NetBank was the largest U.S. banking failure in 14 years, observing in
sum that weak underwriting, a lack of internal controls and a late push into subprime
mortgage lending was the simple recipe for failure.
268. Ultimately, on September 28, 2007, the OTS announced in a press
release that it had taken the extraordinary act of closing NetBank and appointed the
Federal Deposit Insurance Corporation (FDIC} as receiver, explaining that (emphasis
added):
NetBank sustained significant losses in 2006 primarily due to early
payment defaults on loans sold, weak underwriting, poor
documentation, a lack ofproper controls, andfailed business strategies.
269. NetBank's lack of effective internal controls was also specifically cited
by in the OIG Audit Report as having led to the huge mortgage losses suffered by the
Company, which was in turn one of the significant causes of NetBank' s failure:
Ineffective Internal Controls Over Operations
Certain internal controls overNetBank's operations were ineffective. For
example, rather than monitoring or instituting triggers to curtail its
mortgage banking operations when economic conditions warranted such
restrictions, NetBank's strategy continued to emphasize increased loan
production, accomplished by lowering underwriting and documentation
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standards. Products such as "low-doe" and "no-doc" loans allowed
borrowers to obtain loans without demonstrating their ability to repay
the loan. In addition, underwriters reported to individuals who marketed
and sold loans, and sales personnel pressured underwriters to approve
loans.
Lowered underwriting standards led to poor loan quality, which led to
loan repurchases, which led to large losses. In 2006, NetBank
repurchased $ 1.82 million in loans that it had sold and ultimately booked
$78 million dollars in loss provisions associated with the repurchases.
The large losses resulting from loan repurchases significantly
contributed to NctBank's failure.
270. The responsibility for preparing the financial statements in conformity
with GAAP lies with the company's management. Specifically , defendant Herbert as
NetBank's CFE and CEO, at times relevant during the Class Period, was directly
responsible for ensuring that NetBank's financial statements were prepared in
conformity with GAAP. Similarly, as CEO of the Company at times relevant during
the Class Period, defendant Freeman was also responsible for. ensuring that
NetBank's financial statements were prepared in conformity with GAAP.
271. AICPA Auditing Standards § ("AU") 110 Responsibilities and
Functions off the Independent Auditor ("AU 110"), in relevant part, mandates
management's responsibility for preparing the financial statements in conformity with
GAAP as follows:
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The financial statements are management's responsibility ....
Management is responsible for adopting sound accounting policies and
for establishing and maintaining internal control that will, among other
things, initiate, authorize, record, process, and report transactions (as
well as events and conditions) consistent with management's assertions
embodied in the financial statements. The entity's transactions and the
related assets, liabilities, and equity are within the direct knowledge and
control of management.. ..Thus, the fair presentation of financial
statements in conformity with generally accepted accounting principles
is an implicit and integral part of management's responsibility.
(AU 110.03) (Footnote omitted.)
272. As alleged herein, prior to and throughout the Class Period, Defendants
caused NetBank to significantly expand. its involvement with non-conforming and
other non-traditional loans relative to its core business (subsequently "other non-
traditional" loans). NetBank"s expansion into the non-conforming and other non-
traditional loan markets, paired with materially inadequate and ineffective controls
and underwriting guidelines, exposed the Company to a significant concentration of
inherently high risk loans. That concentration, in combination with certain prevailing
market conditions, such as declining home values and increasing credit delinquencies
and defaults, impaired the Company's financial position and caused significant
declines in the Company's results of operations during the Class Period. However,
NetBank failed to timely recognize material known losses (i.e., impairments)
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regarding significant increases, primarily because ofthe Company's exposure to non-
conforming loans, of certain liabilities relevant financial statements.
273. In addition to NetBank's failure to timely recognize material known
impairments, the Company's relevant financial statements also failed to timely
recognize known impairment losses regarding its non-conforming and other non-
traditional loan operations.
274. In addition to NetBank' s failure to timely recognize material known
impairment losses, as alleged above, the Company's relevant financial statements also
significantly overstated the value of certain n ort gage-related assets. As a result,
NetBank failed to timely recognize the losses related to the overstatement ofthe value
of certain of its mortgage related assets. The effect ofNetBank's failure to recognize
known material impairment losses and the overstatement of its mortgage related
assets artificially inflating net earnings.
275. As a result of the foregoing, NetBank lacked effective disclosure
controls and procedures, and internal control over financial reporting, despite
repeated certifications of certain Defendants and other statements to the contrary.
276. Further, the Company's relevant financial statements presented the
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Company's financial position and results of operations in a manner which, among
other things, also violated the following fundamental accounting principles:
(a) The principle that financial reporting should provide information thatis useful to present and potential investors and creditors and other usersin making rational investment, credit and similar decisions (I ASCON
1, ¶34);
(b) The principle that financial reporting should provide information
about the economic resources of an enterprise, the claims to those
resources, and the effects oftransactions, events, and circumstances that
change resources and claims to those resources (FASCON 1, ¶40);
(c) The principle that financial reporting should provide information
about an enterprise' s financial performance during a period. "investors
and creditors often use information about the past to help in assessing
the prospects of an enterprise . Thus, although investment and credit
decisions reflect investors ' and creditors ' expectations about future
enterprise performance, those expectations are commonly based at least
partly on evaluations of past enterprise performance." (FASCON 1,
¶42);
(d) The principle that financial reporting should. provide information
about how management of an enterprise has discharged its stewardship
responsibility to owners (stockholders) for the use of enterprise
resources entrusted to it. "To the extent that management offers
securities of the enterprise to the public, it voluntarily accepts wider
responsibilities for accountability to prospective investors and to the
public in general." (FASCON 1, ¶50);
(e) The principle that financial reporting should be reliable in that it
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represents what it purports to represent. That information should be
reliable as well as relevant is a notion that is central to accounting
(FASCON 2, ¶J58-59);
(f) The principle of completeness , which means that nothing material is
left out ofthe information that may be necessary to ensure that it validly
represents underlying events and conditions (FASCON 2, ¶79);
(g) The principle that financial reporting should be verifiable in that it
provides a significant degree of assurance that accounting measures
represent what they purport to represent (FASCON 2, ¶81); and
(h) The principle that conservatism be used as a prudent reaction touncertainty to try to ensure that uncertainties and risks inherent inbusiness situations are adequately considered . (FASCON 2, ¶¶95, 97).
277. Each of the improper accounting practices , misrepresentations and
omissions engaged in by Defendants , and discussed further herein, standing alone,
was a material breach of GAAP and/or SEC regulations.
B. Understatement of Representations and Warranties Liability
278. Defendants caused the Company to issue the relevant financial
statements, which failed to timely recognize known losses regarding significant
increases of certain liabilities - primarily because of the Company's exposure to non-
conforming loans.
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279. According to a confidential witness, who was a senior executive of
Netl3ank during the entire Class Period, and who had regular daily interaction with
defendants Freeman, Herbert and Gross, defendants Herbert and Gross, at a
minimum, knew that the Company's underwriting guidelines were insufficient. As a
result, the reserves that NetBank knew or should have know were necessary, were not
established. Prior to 2005, NetBank's trend analysis for the previous 8-9 years
showed that the Company's reserves needed to be in the range or I and -3) basis points.
However, beginning as early as 2005, NetBank's analysis changed dramatically,
showing that the Company needed to increase its reserves to between 12 and 14 basis
points.
280. The NetBank Regional Operating Center (ROC) handled the
underwriting of the subprime loans for Meritage. Decisions for the sub-prime
underwriting were made by Doug Freeman, Russell Burdsall, NetBank Head of
Mortgage Operations , and William (Micky) Ross, the NetBank Chief of Sales and
Fulfillment. By early 2006, it became clear that the Meritage subprime lending was
heading in the wrong direction and as a result, the financial position ofNetBank was
so severely damaged that the Company was facing the threat of breaching the
minimum 10% capital ratio required of NetBank in a separate but undisclosed
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agreement with the OTS.
281. Notwithstanding the Defendants' knowledge that NetBank's own
analysis indicated that its reserves were severely deficient, on August 3, 2005,
Defendant Herbert represented in a conference call with analysts: "I mean as soon we
become aware of a loan in a problem, we allocate reserves to it, based upon our
expected sales price."
282. As early as November 14, 2005, Defendant Freeman attempting to
distance the troubled loans at NetBa.nk from those in the industry, but recognizing
that the risks to lenders such as NetBank were increasing, stated that:
SY JACOBS: [I]s there any consistency between this group of loans
we're talking about, the $3.5 million and then the smattering of other
buybacks are having to do -- is there some industry trend developing
here where there is an increase in fraud and loan buybacks, and they
have to do with the petering out of the housing boom?
DOUG FREEMAN: There are no relationships between the process-
driven ones and this group of loans, but I will tell you that T think the
risk profile in the mortgage business is going up -- me and everybody
else in the industry has a lot of writings on that.
283. Similarly, during the same call, Herbert stated:
There are specific products that can cause a problem from time to time,
but a lot of what we're seeing in the industry now is that the whole loan
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buyers, which this was not the common practice for them are now going
through some changes, we believe, anyway, and becoming more
aggressive about putbacks.
We do feel that the current assumption set that we have, you know, as
we look at recent behaviors, more recent frequency behaviors, that the
frequency assumptions that we're making concern in the future are much
more consistent with recent experience and have sort of lined up and
trued up with them so we feel, in general, better about the overall level
of the reserves that we have and the probability that it will be more
predictive of the future than it's been here in the past several quarters.
284. Despite Freeman's acknowledgment of the increased risks in the
mortgage business, NetBank failed to adjust its reserves and risk management to
compensate.
285. At the same time, in addition to their stated belief in the increased risks,
according to a confidential witness who, during most of the Class Period, was senior
managerial executive of Meritage, the Defendants were aware of certain difficulties
with subprime mortgage underwriting guidelines which resulted in NetBank taking
back mortgages that it should not have been accepting.
286. The Company described its representations and warranties liability in the
Business section and Management ' s Discussion and Analysis of Financial position
and Results of Operations section ("MD&A") of its Form 10-K filed March :l 5, 2006
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("2005 Form 10-K"), as follows:
We make representations and warranties in the ordinary course of
business to purchasers and insurers of our mortgage loans and the
purchasers of our mortgage servicing rights regarding compliance with
laws, regulations and program standards and as to accuracy of
information. We may become liable for certain damages or may be
required to repurchase a loan if there has been a breach of
representations or warranties. For example, for certain loan sale
agreements, we are liable to thepurchaser ofthe loans ifan underlying
borrower defaults on the first payments due or if the borrower prepays
the loan shortly after sale. (2005 Form 10-K p. 38) (Emphasis added.)
The majority of our non-performing loans held for sale consist of loans
which the Company has been required to repurchase under
representations and warranties provided to purchasers ofour loans. Once
a loan has been repurchased, it is generally resold at a loss. Upon
repurchase, the Company transfers reserves from its liability for
representations and warranties to a valuation reserve for repurchased
loans to record such loans at estimated net realizable value. (2005 Form
I OK p. 58) (Emphasis added.)
287. GAAP, specifically, FAS 140, Accountingfor Transfers and Servicing
of Financial Assets and Extinguishinents of Liabilities (a replacement of FASB
Statement No. 125) ("FAS 140"), required the Company to recognize liabilities
incurred in the sale of its loans at fair value . FAS 140 provides , in relevant part:
Upon completion of a transfer of assets that satisfies the conditions to
be accounted for as a sale..., the transferor (seller) shall:
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a. Derecognize all assets sold
b. Recognize all assets obtained and liabilities incurred in
consideration as proceeds ofthe sale, including cash, put
or call options held or written ( for example, guarantee or
recourse obligations), forward commitments ( for example,
commitments to deliver additional receivables during the
revolving periods of some sccuritizations ), swaps (for
example, provisions that convert interest rates from fixed
to variable), and servicing liabilities, if applicable...
C. Initially measure at fair value assets obtained and
liabilities incurred in a sale... or, if it is not practicable to
estimate the fair value of an asset or a liability, apply
alternative measures...
d. Recognize in earnings any gain or loss on the sale.
The transferee shall recognize all assets obtained and any liabilities
incurred and initially measure them at fair value (in aggregate,
presumptively the price paid). (FAS 140 ¶1 l) (Certain emphasis in
original and certain emphasis added.) (Footnote omitted.)
288. NetBank had an inventory of mortgages for which they maintained
servicing rights which was handled by the NetBank Treasury Group. In most cases,
NetBank's prime mortgages were sold to Fannie Mae and NetBank earned money by
retaining the servicing rights. Under FAS 133, NetBank was required to show its
hedge effectiveness and performed calculations in an attempt to do so. However,
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according to a confidential witness who was a senior executive ofNetBank during the
entire Class Period and who had regular daily interaction with defendants Freeman,
Herbert and Gross, E&Y advised NetBank and its senior management that the
Company's hedge effectiveness testing under FAS 133 was not being conducted
frequently enough to be reliable and directed NetBank to perform the hedge-
effectiveness on a daily basis. E&Y also directed NetBank to re-calculate the hedge-
effectiveness for previous years back to 2002.
289. According to a confidential witness, who was a senior executive of
NetBank during the entire Class Period, and who had regular daily interaction with
defendants Freeman, Herbert and Gross, NetBank was also in negotiations with the
SEC regarding the frequency with which it performed its hedge-effectiveness under
FAS 133. Ultimately, NetBank reached an agreement with the SEC in which the SEC
would permit NetBank to perform a re-calculation for one month out of each quarter
to demonstrate that the hedging was effective. However, E&Y refused to accept the
proposal claiming that it did not believe that it was adequate. For its part, NetBank
and its senior management, upon information and belief, refused to accept the
assessment of E&Y. On that basis, among others, E&Y resigned as the NetBank
auditors.
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290. FAS 5, A ccounting for Contingencies ("FAS 5 "), provides further
guidance regarding recognition of loss contingencies. FAS 5 provides, in relevant
part:
For the purpose of this Statement, a contingency is defined as an
existing condition, situation, or set of circumstances involving
uncertainty as to possible gain (hereinafter a "gain contingency") or loss
(hereinafter a "loss contingency") to an enterprise that will ultimately be
resolved when one or more future events occur or fail to occur.
Resolution of the uncertainty may confirm the acquisition ofan asset or
the reduction of a liability or the loss or impairment of an asset or the
incurrence of a liability. (FAS 5 ¶1) (Footnote omitted.)
An estimated loss from a loss contingency (as defined in paragraph 1)
shall be accrued by a charge to income if both of the following
conditions are met:
a. Information available prior to issuance of the financial
statements indicates that it is probable that an asset had
been impaired or a liability had been incurred at the date
of the financial statements. It is implicit in this condition
that it must be probable that one or more future events will
occur confirming the fact of the loss.
b. The amount of loss can be reasonably estimated. (FAS 5¶8) (Emphasis added.) (Footnotes omitted.)
29 1. Defendants failed to adequately consider known breaches of
representations and warranties and the related losses that were both probable and
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reasonably estimable. As noted in the Company's 2005 Form 10-K and excerpted
above, the amount of the Company's repurchase obligation, and corresponding losses,
related to representations and wan-antics was in part dependent upon the amount of
early defaults . As of the establishment of the representation and warranties liability
at time loan sales, and subsequently, Defendants were aware, or should have been
aware, of the significant probability of substantive early defaults because the
Defendants were aware, or should have been aware, of the poor, and continually
deteriorating, credit quality of the non-conforming loans sold as Defendants
originated. or purchased, presumably following appropriate due diligence, such non-
conforming loans. As discussed in greater detail elsewhere herein, Defendants were
aware, or should have been aware, of certain prevailing market conditions, such as
declining home values and increasing credit delinquencies and defaults , which further
increased the probability of early defaults. Defendants were aware, or should have
been aware , that the Company's lax underwriting guidelines exposed the Company
to the significant probability of additional breaches of its representations and
warranties regarding the loans sold which were originated by the Company.
292. Defendants disregarded such indications of the Company's true losses
regarding its representations and warranties liability; however, Defendants were
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aware of increasing losses as early as 2003. The Company's representations and
warranties liability at the initial purchase of its non-conforming loan operations (part
of the Resource acquisition as discussed in greater detail elsewhere herein) was
determined to be inadequate in the year immediately following the year of the
acquisition. In the Company's 2003 Form 10-K, filed with the SEC March 1.2, 2004,
Defendants disclosed that the purchase price allocation had to be adjusted for
additional representations and warranties liability. The 2003 Form 10-K reported:
The Company recorded a $2.9 million purchase accounting adjustment
due to certain pre-acquisition contingencies related to representations
and warranties related to loans sold by Resource to third party
purchasers prior to its acquisition by the Company. (2003 Form 10-K p.
85)
293. On May 4, 2005, defendant Herbert assured the investing public that the
Company had done so:
JOT IN HACKETT: That's sufficient for me. Thanks. With respect to the
loan loss provision, you referred to some of the provisions from the
dealer services that just as the portfolio matures. In the press release, it
looks like you referred to some height provision expenses in the
nonprime, nonconforming market. Can you give us a little more color on
that? Was there some credit going on in the mortgage side?
STEVE HERBERT: Yes. For the past three quarters what we are doing
there, we are really providing far what is called FIN 45 reserves. That's
life -- every time we sell a loan, there is a possibility that it will be put
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back due to standard reps and warranties, either for fraud or for basically
early payment default.
There are really two components to that long-teen calculation. One is
the frequency with which you will have to repurchase those loans, and
one is the severity. All our analysis continues to consolidate at a very
stable overall severity level. We feel very, very comfortable from the
over 6-7 year's worth of data that we know what on average we are
going to lose on those loans.
What we have seen in the last three quarters is an increase in the
frequency early in the life cycle ofcertain vintages ofproducts. That sort
of begs the question of will the fully seasoned frequency ofrepurchases
be higher because the early repurchase activity is higher than what we
have seen in the past or is the industry getting better at putting loans
back faster?
We do have some terminal points on the overall repurchase timelines,
but the bottom line is we have seen trends that have caused up to
increase, not the severity levels, but our expected cumulative frequency
expectations and we've made the necessary adjustments through
provision expense to put reserves out there for that. We are, and do
believe, that those numbers will stabilize in the future. We don't know
whether that has already happened or whether it will happen next quarter
or two quarters forward, because of the process we use we can't tell you
for sure when that will be. We can tell you that our process is responsive
to the data as it comes in and we are continuing to do some analysis
there to get at some of the root causes of what, where these repurchases
are coming from.
294. Later in that same conference call, Freeman reassured the investing
public of the reliability of NetBank's share price stating:
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We are experiencing some decent growth in the bank. We do pay a
dividend. We still have MNA obligations to build out our transaction
processing business and we still like the investment in our stock around
value, so all I can tell you is we try very hard to strike a balance between
all of those initiatives that we have underway.
295. On August 3, 2005, during a conference call with analysts, Defendant
Freeman again assured the investing public of the reliability ofNetBank's shareprice
stating:
We continue to manage capital in a very disciplined, proactive manner,
with an eye toward generating the greatest value for you, our
shareholder. During the second quarter, we repurchased
approximatelyl 50,000 shares at an average cost of S8.46 a share.
296. Defendants eventually acknowledged the following in the
MD&A of its 3Q2006 Form 10-Q tiled with the SEC November 9, 2006
regarding its representations and warranties liability, in relevant part:
Documentation. Repurchases related to documentation have increased
in recent years. During the last three years, NetBank produced and sold
a large volume of affordable housing program loans to FNMA. The
underwriting and. documentation requirements under such programs are
different than with traditional agency-eligible products in which the
Company regularly deals and have resulted in a greater number of
documentation deficiencies and consequently an increase in the volume
ofrepurchases.
^4 Y>kY
Early payment default. As is customary in whole loan sales, NetBank
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provides early payment default protection to the buyers. All offour sales
from our non-conforming channel are whole loan sales. The increased
production in this channel in recent years has given rise to an increase
in repurchase volumes for early payment default. Likewise,
commencing in 2004 and continuing in 2005 and 2006, our third party
conforming channel sold larger percentages of loans in whole loan sales
as opposed to agency mortgage backed securities, resulting in increases
in repurchase volume related to early payment default because whole
loan buyers are more likely to require sellers to repurchase loans in the
case of early payment default. (Q3 2006 Form I 0-Q p. 27) (Emphasis
added.)
297. Despite declining sales volumes the Company was incurring increasing
repurchase volumes. The increase in the Company's repurchase obligation had a
material impact on its results of operations, and consequently, its financial position.
The Company reported, although still insufficiently, related losses, in its Q3 2006
Form l0-Q, in relevant part:
...gain on sales of loans declined $23,118 during the three months
ended September 30, 2006 as compared to the same period in 2005
primarily due to continued competitive pressures within the secondary
market and higher repurchase volumes. (Q3 2006 Form l0-Q p. 29)
(Dollars in thousands.)
298. Finally, in the Company 's earnings release for the fourth quarter of2006
dated February 21, 2007, Defendants acknowledged, in relevant part:
As previously announced, repurchase requests in the non-conforming
mortgage channel rose sharply following management's decision to
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close the business and accelerated further at the end of the year.
Provisions for the non-conforming channel were $30.3 fnillion, an
increase of$25.7 million f-oni last quarter. Overall, provisions for the
financial intermediary segment were 532.0 million versus $12.2 million
the prior quarter. Management believes the worst ofthe non-conforming
loan repurchase problem is now behind the company given the
accelerated repurchase requests already received relative to the limited
non-conforming production over the second half of 2006.
299. As a result of Defendant' s failure to timely recognize known losses
regarding its representations and warranties liability, the Company's relevant
financial statements materially understated the Company's total liabilities and
materially overstated net income (or understated net losses, as applicable). Therefore,
the Company's relevant financial statements were materially false and misleading
regarding the Company's results of operations and financial position, and thus, were
not presented in conformity with GAAP.
C. Undisclosed Impairment of Goodwill
300. Additionally, as a result of the Defendant's failure to timely recognize
known losses regarding its representations and warranties liability, Defendants caused
the Company to issue the certain of the relevant financial statements which failed to
timely recognize impairment losses regarding the Company's non-conforming loan
operations and other non-traditional loan operations, specifically, regarding goodwill.
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301. Goodwill, generally, is the premium paid in an acquisition above the
acquired entity's identifiable fair value and, if any, is reported as an asset by the
acquiring entity. GAAP, specifically , FAS 142, Goodwill and Other Intangible Assets
("FAS 142"), requires goodwill to evaluated for impairment if an event occurs or
circumstances change that would more likely than not reduce the fair value of a
reporting unit (i.e. Heritage, the Company 's non-conform ing loan operations, or
Beacon, the Company's other non-traditional loan operations) below its carrying
amount, but, at a minimum, annually. (FAS 142 1128) (Emphasis added.) FAS 142,
further provides the guidance for recognizing and measuring goodwill impairment,
if any. FAS 142 requires a two-step process whereby an entity first determines if the
carrying value of a reporting unit exceeds the fair value of such reporting unit, and,
if so, then measures and recognizes the amount of impairment loss, if any, as the
amount that the carrying value of reporting unit goodwill exceeds the implied fair
value of such goodwill. (FAS 142 ¶28).
302. Had Defendants timely recognized known losses regarding its
representations and warranties liability, such losses would have been an indication
that, more likely than not, the fair value of the Company's non-conforming loan
operations had been reduced below its carrying value, thereby requiring an evaluation
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of goodwill impairment resulting in the timely recognition of impairment losses.
Defendants disregarded its true losses regarding the Company's representations and
warranties liability, and thereby disregarded significant indication of the impairment
of goodwill related to its non-conforming loan operations, and avoided timely
recognizing the impairment losses.
303. Finally, as the indications of the impairment of goodwill related to its
non-conforming loan operations could not be further concealed, in the Company's
third quarter 2006 interim financial statements, the Defendants acknowledged, in
relevant part:
As a result of the Company's most recent impairment analyses,
performed during the third quarter of 2006, management recorded a
goodwill impairment of$19, 505 related to our nonconforming mnortgage
operations. The impairment charge eliminated all of the goodwill
related to our nonconforming operations and the Company received no
tax benefit from this charge. (Q3 2006 Form 10-Q p. 16) (Emphasis
added.)
304. As a result of Defendant ' s failure to timely recognize goodwill
impairment losses regarding its non-conforming loan operations, the Company's
relevant financial statements, exclusive of its third quarter 2006 interim financial
statements, materially overstated the Company's total assets and materially overstated
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net income (or understated net losses, as applicable). Therefore, the Company's
relevant financial statements, exclusive of its third quarter 2006 interim Financial
statements, were materially false and misleading regarding the Company's results of
operations and financial position, and thus, were not presented in conformity with
GAAP.
305. Similarly, had Defendants timely recognized known losses regarding its
other non-traditional loan operations, such losses would have been an indication that,
more likely than not, the fair value of such reporting unit (i.e., Beacon) had been
reduced below its carrying value, thereby requiring an evaluation of goodwill
impairment, resulting in the timely recognition ofimpairment losses. As discussed in
greater detail elsewhere herein, the Company's expansion away from its core business
and into the other non-traditional loan market , paired with lax underwriting
guidelines, exposed the Company to a significant concentration of inherently high-
risk loans. Further, as discussed in greater detail elsewhere herein, Defendants were
aware, or should have been aware, that concentration, in combination with certain
prevailing market conditions, such as declining home values and increasing credit
delinquencies and defaults, impaired the reporting unit's financial position and
caused significant declines in the reporting unit's results of operations. Defendants
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disregarded significant indications of the impairment of goodwill regarding its other
non-traditional loan operations and avoided timely recognizing the impairment losses.
306. As the indications ofthe impairment ofgoodwill regarding its other non-
traditional loan operations could not be further concealed, in the Company's Form 10-
Q for 2Q2006, filed with the SEC on August 8, 2006 , the Defendants admitted, in
relevant part as follows:
During the preparation and review of the these financial statements,
management determined, based. on currently available market
information as well as general trends in the industry, to record a
goodwill impairment of $6,358 with respect to the second quarter of
2006 related to our 2004 acquisition of Beacon Credit Services. The
impairment charge eliminated all ofthe goodwill related to the Beacon
acquisition. (Q2 2006 Form 10-Q p. 17) (Emphasis added.)
307. As a result of Defendant's failure to timely recognize goodwill
impairment losses regarding its other non-traditional loan operations goodwill, the
Company's relevant financial statements, exclusive of its second and third quarter
2006 interim financial statements, materially overstated the Company's total assets
and materially overstated net income (or understated net losses, as applicable).
Therefore, the Company's relevant financial statements, exclusive of its second and
third quarter 2006 interim financial statements, were materially false and misleading
regarding the Company's results of operations and financial position, and thus, were
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not presented in conformity with GAAP.
308. NetBank's difficulties arising from Beacon were, in part, the result of
NetBank's failure to conduct due diligence prior to the acquisition. According to a
confidential witness, who was a senior executive ofNetBank during the entire Class
Period, and who had regular daily interaction with. defendants Freeman, Herbert and
Gross, it was defendant Freeman who made the decision for NetBank to purchase
Beacon , the financier of watercraft and aircraft . After the decision was made,
defendant Gross traveled to Connecticut to examine Beacon's books and records prior
to the sale. However, Gross was not permitted by Beacon to adequately examine those
books and records and a recommendation was made not to proceed with the purchase.
According to a confidential witness , who was a senior executive of NetBank during
the entire Class Period, and who had regular daily interaction with defendants
Freeman, Herbert and Gross, the principal of Beacon, at the time of the acquisition
by NetBank, was John Redmond who was a close personal friend of defendant
Freeman. Nevertheless, defendant Freeman disregarded the fact that Beacon would
not make its books and records available for inspection and the recommendation not
to purchase the company and pushed through the approval ofthe purchase ofBeacon
for $6.8 million. According to a July 2, 2004, press release issued by NetBank,
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Redmond, then a member of Beacon's senior management team , was poised to join
NetBank to oversee the Beacon division.
309. After acquiring it in .tune , 2004, Beacon caused NetBank to suffer a loss
of between approximately $200,000 and $300,000 every month, until the company
was essentially given back to Defendant Freeman's personal friend, Redmond, at no
cost in October 2006. The decisions o F the NetBank. Board of Directors were greatly
influenced by William (Mickey) Ross as they pertained to Beacon who operated
under the direction of Defendant Freeman. According to a confidential witness, who
was a senior executive of NetBank during the entire Class Period, and who had
regular daily interaction with defendants Freeman, Herbert and Gross, at least with
respect to the Beacon, Defendant Freeman effectively over-rode decisions of the
NetBank Board of Directors' and instead imposed conduct that he knew was not in
the best interest of NetBank or its investors. As alleged herein, also according to a
confidential witness who was a senior executive ofNetBank during the entire Class
Period and who had regular daily interaction with defendants Freeman, Herbert and
Gross, the Beacon transaction and related exotic lending programs were one of the
major contributing factors to NetBank's demise.
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A Overstatement of Mortgage-Servicing Rights Assets
310. Defendants caused the Company to issue the relevant financial
statements which failed to timely report known impairment losses regarding certain
of the Company's mortgage-related assets, specifically, mortgage-servicing rights
("MSRs").
311. MSRs, generally, are the expected future servicing revenues in excess
of expected future servicing expenses related to the servicing of a pool ofrnortgages.
GAAP, specifically, FAS 140, requires MSRs , subsequent to their initial recognition,
to be reported at the lower of cost or fair value. FAS 140 provides, in relevant part-
A servicer that recognizes a servicing asset... shall account for the
contract to service financial assets separately from those assets, as
follows:
f. Subsequently measure servicing assets by amortizing the
amount recognize-d in proportion to and over the period of
estimated net servicing income-the excess of servicing
revenues over servicing costs...
g. Subsequently evaluate and measure impairment of
servicing assets as follows:
(1) Stratify servicing assets based on one or more of thepredominant risk characteristics of the underlyingfinancial assets. Those characteristics may includefinancial asset type, size, interest rate, date of
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origination, term, and geographic location.
(2) Recognize impairment through a valuation
allowance for an individual stratum . The amount of
impairment recognized shall be the ainount hy which
the carrying amount of servicing assets Jrc)a
stratum exceeds their fair value. The fair value of
servicing assets that have not been recognized shall
not be used in the evaluation of impairment.
(3) Adjust the valuation allowance to reflect changes in
the measurement ofimpairment subsequent to the
initial measurement of impairment. Fair value in
excess ofthe carrying amount of'servicing assets for
that stratum, however, shall not he recognized. This
Statement does not address when an entity should
record a direct write-down of recognized servicing
assets... (FAS 140 1[63) (Emphasis added.) (Footnote
omitted.)
312. Changes in the fair value of MSRs are caused by changes in the
underlying pool ofmortgages. The Company indicated the following, in relevant part,
regarding the value of its MSRs:
An increase in delinquencies and defaults ofmortgage loans will also
adversely impact our loan servicing operations. Under certain types of
servicing contracts, particularly contracts to service pooled or
securitized loans, we must advance all or part ofthe scheduled payments
to the owner ofthe loan, even when loan payments are delinquent. Also,
to protect their lien on mortgaged property, owners of mortgage loans
usually require us to advance mortgage and hazard insurance and tax
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payments on schedule even if sufficient escrow funds are unavailable.
A services is generally reimbursed for such advances by the mortgage
loan owner or from liquidation proceeds. However, prior to the
liquidation ofa loan, we Inust generally bear the cost offunds advanced
and the increased costs oJ' attempting to collect on delinquent and
defaulted mortgage loans. In addition, we must generally forego
servicing incomefrom the time such loan becomes delinquent until it is
,foreclosed upon or brought cur•r°ent. (2005 Form 10-K p. 38)
313. According to the Company's disclosures, its MSRs primarily related to
agency-eligible loans. Defendants described agency-eligible loans as follows:
Agency-eligible mortgage loans are those mortgage loans that meet the
size, documentation, borrower and credit standards to qualify to be
pooled into mortgage-backed securities guaranteed by government
sponsored enterprises, such as Fannie Mae, Freddie Mae and Ginnie
Mae. (2005 Form 10-K p. 13)
314. Thus, although agency-eligible loans would have typically excluded non-
conforming loans, based on the Company's definition and lack of any statements to
the contrary, it is reasonable to conclude such agency eligible loans included the
Company's other non-traditional loans, which was not the Company's core business,
and included those other non-traditional loans originated by the Company subject to
the Company's lax underwriting guidelines. Such factors, known to the Defendants,
and in combination with certain prevailing market conditions, such as declining home
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values and increasing credit delinquencies and defaults, as discussed in greater detail
elsewhere herein, caused significant declines in the fair value of its MSRs.
Defendants disregarded the significant indications ofthe impairment ofits MSRs and
avoided timely recognizing the related known impairment losses.
315. Finally, as the Company was forced to sell-off a significant portion its
MSRs, the impairment of its MSRs could not be further concealed, Defendants
acknowledged, although still insufficiently, for the three months ended September 30,
2006, losses on sales ofM5Rs of$29.8 million, in addition to iVISR impairment losses
f r the three and nine months ended Septenmber 30, 2006 of, respectively, $ 1.5 million
and $7.4 million. (Q3 2006 Form I0-Q p. 4) Not until the second quarter of 2007 did
Defendants acknowledge, on the Company's Form 8-K filed with the SEC June 21,
2007, additional expected losses of $7.5 million on the sale of the Company's
remaining MSRs.
316. As a result of Defendant 's failure to timely recognize known losses
regarding the impairment of its MSRs, the Company's relevant financial statements
materially overstated the Company's total assets and materially overstated net income
(or understated net losses, as applicable). Therefore, the Company's relevant financial
statements were materially false and misleading regarding the Company's results of
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operations and financial position, and thus, were not presented in conformity with
GAAP.
E. Ineffective Disclosure Controls and Procedures and
Internal Control. over Financial Reporting
317. The SEC defines "disclosure controls and procedures" as:
...controls and other procedures of an issuer that are designed to ensure
that information required to he disclosed by the issuer in the reports
filed or submitted by it under the Exchange Act is recorded, processed,
summarized and reported, with the time periods specified in the
Commission 's rules and forms.... (SEC Final Rule Release Nos. 33-
8124, 34-46427, IC-25722; File No. S7 -21-02) (emphasis added and
footnotes omitted).
318. Internal control over financial reporting is defined in Public Company
Accounting Oversight Board ("PCAOB") Auditing Standard No. 2, An Audit of
Internal Control Over Financial Reporting.Perfbrmed in Conjunction with An Audit
ofFinancial Statements ("AS 2"), as follows, in relevant part:
A process designed by, or under the supervision of, the company's
principal executive and principal financial officers, or persons
performing similar functions, and effected by the company's board of
directors, management, and other personnel, to provide reasonable
assurance regarding the reliability of financial reporting and the
preparation qffinancial statementsfor externalpurposes in accordance
with, generally accepted accounting principles and includes those
policies and procedures that:
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(1) Pertain to the maintenance of records that, in reasonabledetail, accurately and fairly reflect the transactions anddispositions of the assets of the company;
(2) Provide reasonable assurance that transactions are recorded
as necessary to permit preparation of financial statements
in accordance with generally accepted accounting
principles, and that receipts and expenditures of the
company are being made only in accordance with
authorizations of management and directors of the
company; and
(3) Provide reasonable assurance regarding prevention ortimely detection of unauthorized acquisition, use ordisposition of the company's assets that could have amaterial effect on the financial statements.
Notably, the above definition is the same one used by the SEC in its rules requiring
management to report on internal control over financial reporting, except the word
"registrant " has been changed to "company" to conform to the wording in this
standard . (See Exchange Act Rules 13a-15(1) and 15d - 15(t).2/) (AS 2 ¶¶7).
319. Exchange Act Rules 13a- 14 and 15d-14 require the Company's principal
executive officer and principal financial officer, or equivalents, to quarterly and
annually certify the effectiveness (or disclose deficiencies in the effectiveness, as
applicable) of the Company's disclosure controls and procedures as of an assessment
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date within 90 days prior to the filing date of the report. Further, the Company is
required to annually report on the effectiveness of its internal control over financial.
reporting. Auditing Standard No. 2 states, in relevant part:
A company subject to the reporting requirements of the SecuritiesExchange Act of 1934 (an "issuer") is required to include in its annualreport a report of management on the company's internal control overfinancial reporting... The report of management is required to containmanagement's assessment ofthe effectiveness ofthe company's internalcontrol over financial reporting as of the end of the company's mostrecent fiscal year, including a statement as to whether the company'sinternal control over financial reporting is effective... (AS 2 ¶2).
320. During the Class Period, Defendants caused the Company to issue
materially false and misleading statements regarding the effectiveness of the
Company's disclosure controls and procedures, and internal control over financial
reporting. With the exception of December 31, 2004, Defendants disclosed the
Company's disclosure controls and procedures were effective as of the date of each
individual Exchange Act report that was filed during the Class Period. (Q1 2005
Form 10-Q p. 28, Q2 2005 Form 10-Q p. 3 6, Q3 2005 Form 10-Q p. 37, 2005 Form
1.0-K p. 124, Q 1 2006 Form 10-Q p. 34, Q2 2006 Form 10-Q p. 41, Q3 2006 Form
10-Q p. 39) Further, Defendants disclosed that internal control over financial
reporting as of December 31, 2005. (2005 Form 10-K p. 125).
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32 1. Defendants caused the Company to issue the relevant financial
statements that were materially misstated with respect to the Company's
representations and warranties liability, goodwill, and MSRs and avoided timely
recognizing losses. Defendants caused the Company to issue the relevant financial
statements which were materially false and misleading regarding the Company's
results of operations and financial position, and thus, were not presented in
conformity with GAAP. Thereby, the Company's disclosure controls and procedures,
and internal control over financial reporting, were not effective as of the date of each
individual Exchange Act report that was filed during the Class Period.
XlI. ADDITIONAL SCIENTER ALLEGATIONS
322. As alleged herein, Defendants acted with scienter in that Defendants
knew that the public documents and statements issued or disseminated in the name
of the Company were materially false and misleading; knew that such statements or
documents would be issued or disseminated to the investing public; and knowingly
and substantially participated, approved or acquiesced in the issuance or
dissemination of such statements or documents as primary violations of the federal
securities laws. As set forth elsewhere herein in detail, Defendants, by virtue of their
receipt of information reflecting the true facts regarding NetBank, their control over,
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receipt of and/or modification of NetBank's allegedly materially misleading
misstatements and/or their associations with the Company which made them privy to
confidential proprietary information concerning NetBank, participated in the
fraudulent scheme alleged herein..
323. Among other things, Defendants' scienter is specifically demonstrated
by their intentional and purposeful withholding of information from the investing
public as to the SEC's communications and investigations into the Company's
material misapplication of GAAP and FAS 133 in connection with its financial
reporting with the SEC. Such misapplications materially misstated the Company's
financial statements as to the results and condition of the Company since at least
March 16, 2005. Defendants admit they were notified by the SEC of such accounting
misstatements as early as August 31, 2006, but purposely withheld that information
from the investing public for nearly a year, and finally disclosed such information on
August 10, 2007, when NetBank was in its final throes of its ultimate collapse.
Defendants' withholding of this information was designed to conceal and continue
their fraudulent scheme as alleged.
324. Similarly, Defendants failed to disclose that the resignation ofNetBank's
independent auditor was directly related to the Company's GAAP violations and
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internal control failings, including its misapplication of FAS 133. Indeed , nearly a
year after E&Y resigned, the Company revealed that E&Y had actually withdrawn its
prior audit opinions for NetBank's 2004 and 2005 Form 10-K. E&Y was also then
refusing to allow for NetBank to File its 2006 FormI0-K as a further result.
325. Defendants' scienter is further demonstrated by their intentional and
purposeful failure to file any financial reports with the SEC following the filing ofthe
Form l0--Q for the fiscal quarter ended September 31, 2006..As such, Defendants not
only failed to report timely and accurately NetBank's financial results and condition
after 3Q2006, but Defendants failed to correct and restate the Company prior
financial statements, and instead simply waited for the Company to declare
bankruptcy and dissolve. Defendants' actions and inactions in this regard amounted
to a concerted effort to conceal their fraud as alleged herein.
XIII. LOSS CAUSATION/ECONOMIC LOSS
326. During the Class Period, as alleged. herein, the Defendants engaged in
a scheme to deceive the market and artificially inflate the price of NetBank's
securities . In doing so, Defendants made material misrepresentations and omissions
regarding, among other things, the Company's financial reporting, financial
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condition, internal controls, business operations, corporate restructuring, core
banking business, lending practices and exposure to subprime mortgages. When the
truth concerning these issues was revealed to the investing public beginning on May
21, 2007, the price of NetBank ' s securities materially declined as the remaining
artificial inflation dissipated. As a result of their purchases of NetBank securities
during the Class Period at artificially inflated prices and subsequent disclosures
which removed the inflation from such securities, Plaintiff and other members ofthe
Class suffered economic loss, i.e., damages under the federal securities laws.
327. The markets for NetBank' s securities were open, well-developed and
efficient at all relevant times. As a result of these materially false and misleading
statements and failures to disclose, NetBank's securities traded at artificially inflated
prices during the Class Period. Plaintiff and other members of the Class purchased or
otherwise acquired NetBank securities relying upon the integrity of the market price
of NetBank's securities and market information relating to NetBank, and have been
damaged thereby.
328. During the Class Period, Defendants materially misled the investing
public, thereby inflating the prices of NetBank's securities , by publicly issuing false
and misleading statements and omitting to disclose material facts necessary to make
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Defendants' statements, as set forth herein, not false and misleading. Said statements
and omissions were materially false and misleading in that they fail to disclose
material adverse information and misrepresented the truth about the Company, its
business and operations, as alleged herein.
329. At all relevant times, the material misrepresentations and omissions
particularized in this Amended Complaint directly or proximately caused, or were a
substantial contributing cause of, the damages sustained by Plaintiff and other
members ofthe Class. As described herein, during the Class Period, Defendants made
or caused to be made a series of materially false or misleading statements about
NetBank's business, prospects, operations and results. These material misstatements
and omissions had the cause and effect of creating in the market an unrealistically
positive assessment of NetBank and its business , prospects, operations and results,
thus causing the Company's securities to be overvalued and artificially inflated at all
relevant times.
330. When the full impact of Defendants' prior misrepresentations and
fraudulent conduct were disclosed and became apparent to the market, the prices of
NetBank' s securities fell precipitously as the remaining artificial inflation came out.
As a result of their purchases of NetBank' s securities during the Class Period,
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Plaintiff and the other Class members suffered economic loss, i.e., damages under the
federal securities laws,
331. By failing to disclose the truth about its core businesses, lending policies
and practices and accounting practices, Defendants presented a misleading picture of
NetBank's operations and financial performance. Thus, instead of disclosing during
the Class Period the truth about NetBank's business, prospects, operations and
results, Defendants caused NetBank to conceal the truth.
332. Defendants' false and misleading statements had the intended effect and
caused NetBank's common stock to trade at artificially inflated levels throughout the
Class Period, reaching as high as $8.74 per share on May 16, 2005, the start of the
Class Period.
333. Beginning at least as early as October 2006, adverse facts and
circumstances attributable to the fraud alleged herein were learned by the investing
public, and as a result, the price of NetBank stock suffered numerous declines. This
adverse information included the "resignation", or firing of NetBank CEO Freeman,
the resignation of NetBank's auditor E&Y, reports of dismal financial results,
reported delays in reporting financial data and filing requisite reports with the SEC,
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and the Company's failure to file requisite financial reports with the SEC. "While
these adverse disclosures revealed business reversals caused by defendants' fraud,
and precipitated stock price declines which were the consequence of Defendants'
fraud (and its gradual unraveling), the major elements ofthe fraudulent scheme itself
were not revealed until the Company's shocking disclosures on May 21, 2007, and
thereafter.
334. As a direct result of Defendant s' disclosures on May 21, 2007,
NetBank's common stock price fell precipitously. These drops removed the remaining
inflation from the price of NetBank's securities, causing real economic loss to
investors who had purchased the Company's securities during the Class Period.
335. The approximate 92% decline in the price ofNetBank's common stock
after these disclosures came to light was a direct result of the nature and extent of
Defendants ' fraud finally being revealed to investors and the market. The timing and
magnitude of NetBank's common stock price declines negate any inference that the
loss suffered by Plaintiffand the other Class members was caused by changed market
conditions, macroeconomic or industry factors or Company-specific facts unrelated
to the Defendants' fraudulent conduct. The economic loss, i.e., damages, suffered by
Plaintiff and the other Class members was a direct result of Defendants' fraudulent
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scheme to artificially inflate the prices of NetBank's securities and the subsequent
significant decline in the value of NetBank's securities when Defendants' prior
misrepresentations and other fraudulent conduct were revealed.
336. The price declines directly and proximately resulting from the above
discussed disclosures were not caused by industry news, randomness or by NetBank
related information unrelated to the alleged fraud. Each of the above referenced
disclosures partially corrected the false and misleading information previously
available to the market by the Defendants' wrongful course of conduct. Plaintiff and
the Class seek by this Amended Complaint to be compensated for those resulting
economic losses.
XIV. FRAUD ON THE MARKET DOCTRINE
3 37. Throughout the Class Period the market for NetBank common stock was
an efficient market for the following reasons, among others:
a. NetBank common stock met the requirements ror listing, and was
listed and actively traded on the NASDAQ;
b. As a regulated issuer of securities, NetBank filed periodic public
reports with the SEC and the NASDAQ;
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c. The common stock of NetBank was followed by securities
analysts who wrote research reports that were distributed to brokerage sales personnel
and to customers of investment firms. These research reports were publicly available
and entered the public marketplace; and
d. Plaintiff and the other members of the proposed Class purchased
NetBank common stock and other securities during the time Defendants are alleged
to have engaged in the fraudulent acts and practices alleged herein, and did not know
the truth.
338. The -market for NetBank common stock promptly digested current
information with respect to NetBank common stock from all publicly available
sources, and all such information was reflected in the market prices of said securities.
Under these circumstances, all those who purchased NetBank common stock during
the Class Period suffered similar injury through their acquisition of such securities
at artificially inflated prices. Hence, the fraud-on-the-market doctrine of reliance
applies to the claims alleged herein.
339. At all relevant times, the market for NetBank's securities was an efficient
market for the following reasons, among others:
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(a) NetBank's stock met the requirements for listing, and was listed and
actively traded on the National Association of Securities Dealers Automated
Quotation System ("NASDAQ"), a highly efficient and automated market;
(b) as a regulated issuer, NetBank filed periodic public reports with the SEC
and the NASDAQ;
(c) NetBank regularly communicated with public investors via established
market communication mechanisms, including through conference calls with
investors and the issuance ofpress releases on the national circuits ofmajor newswire
services and through other wide-ranging public disclosures, such as communications
with the financial press and other similar reporting services; and
(d) NetBank was.followed by several securities analysts employed by major
brokerage firms who wrote reports which were distributed to the sales force and
certain customers of their respective brokerage firms. Each of these reports was
publicly available and entered the public marketplace.
340. As a result of the foregoing, the markets for NetBank's securities
promptly digested current information regarding NetBank from all publicly available
sources and reflected such information in the price of the Company's securities.
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Under these circumstances , all purchasers of NetBank 's securities during the Class
Period suffered similar injury through their purchase of the publicly traded securities
of NetBank at artificially inflated prices, and a presumption of reliance applies.
XV. INAPPLICABILITY OF SAFE HARBOR
341. The statutory safe harbor provided for forward-looking statements
("FLS") does not apply to any false FLS that may be pleaded herein. The statutory
safe harbor for FLS does not apply because the safe harbor exempts from coverage
the Company's false financial statements. Moreover, any such FLS pleaded herein
were not specifically identified. as "forward-looking statements" when made and/or
were not accompanied by meaningful cautionary statements identifying important
factors that could cause actual results to differ materially from those in the FLS. To
the extent that the statutory safe harbor may apply to any of these false statements
alleged herein, the Defendants are liable for those false forward-looking statements
because at the time each of those statements was made the speaker actually knew the
statement was false and the statement was authorized and/or approved by an
executive officer of NetBank who actually knew that those statements were false
when made.
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CLAIMS FOR RELIEF
COUNT I
Violation of Section 10(b) of the Exchang e Act and Rule lOb-5
Promulgated Thereunder Against All Defendants
342. Plaintiffrepeats and realleges each and every allegation contained above
as if fully set forth herein.
343. During the Class Period, Defendants carried out a plan, scheme and
course of conduct which was intended to and, throughout the Class Period, did: (i)
deceive the investing public regarding NetBank's business, operations, management
and the intrinsic value of NetBank securities; and (ii) cause Plaintiff and other
members of the Class to purchase NetBank's securities at artificially inflated prices.
In furtherance of this unlawful scheme, plan and course of conduct, Defendants, and
each of them, took the actions set forth herein.
344. Defendants: (a) employed devices, schemes, and artifices to defraud; (b)
made untrue statements of material fact and/or omitted to state material facts
necessary to make the statements not misleading; and (c) engaged in acts, practices,
and a course of business which operated as a fraud and deceit upon the purchasers of
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the Company's securities in an effort to maintain artificially high market prices for
NetBank's securities in violation of Section 10(h) of the Exchange Act and Rule I Ob-
5 promulgated thereunder. All Defendants are sued either as primary participants in
the wrongful and illegal conduct charged herein or as controlling persons as alleged
below.
345. Defendants, individually and in concert, directly and indirectly, by the
use, means or instrumentalities of interstate commerce and/or of the mails, engaged
and participated in a continuous course of conduct to conceal adverse material
information about the business, operations and future prospects of NetBank as
specified herein.
346, These Defendants employed devices, schemes and artifices to defraud,
while in possession of material adverse non-public i.nf'ormation and engaged in acts,
practices, and a course of conduct as alleged herein in an effort to assure investors of
NetBank's value and performance and continued substantial growth, which included
the making of, or the participation in the making of, untrue statements of material
facts and omitting to state material facts necessary in order to make the statements
made about NetBank and its business operations and future prospects in the light of
the circumstances under which they were made, not misleading, as set forth more
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particularly herein, and engaged in transactions, practices and a course of business
which operated as a fraud and deceit upon the purchasers of NetBank's securities
during the Class Period.
347. Each of the Individual Defendants' piiimary liability, and controlling
person liability, arises from the following facts: (i) the Individual Defendants were
high-level executives and/or directors at the Company during the Class Period and
members of the Company's management team or had control thereof, (ii) each of
these Defendants , by virtue of his responsibilities and activities as a senior officer
and/or director of the Company was privy to and participated in the creation,
development and reporting of the Company's internal budgets, plans, projections
and/or reports; (iii) each ofthese Defendants enjoyed significant personal contact and
familiarity with the other Defendants and was advised of and had access to other
members of the Company's management team, internal reports and other data and
information about the Company's finances, operations, and sales at all relevant times
; and (iv) each of these Defendants was aware of the Company"s dissemination of
information to the investing public which they knew or recklessly disregarded was
materially false and misleading.
348. The Defendants had actual knowledge of the misrepresentations and
-202-
Case 1:07-cv-02298-BBM Document 35-3 Filed 07/03/2008 Page 57 of 74
omissions of material facts set forth herein, or acted with reckless disregard for the
truth, in that they failed to ascertain and to disclose such facts, even though such facts
were available to them. Such Defendants ' material misrepresentations and/or
omissions were done knowingly or recklessly and for the purpose and effect of
concealing NetBank's operating condition and future business prospects from the
investing public and supporting the artificially inflated price of its securities . As
demonstrated by Defendants ' overstatements and misstatements of the Company's
business, operations and earnings throughout the Class Period, Defendants, ifthey did
not have actual knowledge of the misrepresentations and omissions alleged, were
sufficiently reckless in failing to obtain such knowledge by deliberately refraining
from taking those steps necessary to discover whether those statements were false or
misleading.
349. As a result of the dissemination of the materially false and misleading
information and failure to disclose material facts, as set forth above, the market prices
ofNetBank' s securities were artificially inflated during the Class Period. In ignorance
ofthe fact that market prices ofNetBank's pu blicly-traded securities were artificially
inflated, and relying directly or indirectly on the false and misleading statements
made by Defendants, or upon the integrity ofthe market in which the securities trade,
-203-
Case 1:07-cv-02298-BBM Document 35-3 Filed 07/03/2008 Page 58 of 74
and/or on the absence of material adverse information that was known to or recklessly
disregarded by Defendants but not disclosed in public statements by Defendants
during the Class Period, Plaintiff and the other members of the Class acquired
NetBank securities during the Class Period at artificially high prices and were
damaged thereby.
350. At the time of said misrepresentations and omissions, Plaintiff and other
members ofthe Class were ignorant of their falsity, and believed them to be true. Had
Plaintiff and the other members of the Class and the marketplace known the truth
regarding NetBank's Financial results, which were not disclosed by Defendants,
Plaintiff and other members of the Class would not have purchased or otherwise
acquired their NetBank securities, or, if they had acquired such securities during the
Class Period, they would not have done so at the artificially inflated prices which they
paid.
351. By virtue of the foregoing, Defendants have violated Section 10(b) of
the Exchange Act, and Rule I Ob-5 promulgated thereunder.
352. As a direct and proximate result of Defendants ' wrongful conduct,
Plaintiff and the other members of the Class suffered damages in connection with
-204-
Case 1:07-cv-02298-BBM Document 35-3 Filed 07/03/2008 Page 59 of 74
their respective purchases and sales of the Company's securities during the Class
Period.
COUNT 1[
Violation of Section 20(a) Of
The Exchange.A.et Against the Individual Defendants
353. Plaintiff repeats and realleges each and every allegation contained above
as if fully set forth herein.
354. The Individual Defendants acted as controlling persons of NetBank
within the meaning of Section 20(a) of the Exchange Act as alleged herein. By virtue
of their high-level positions, and their ownership and contractual rights, participation
in and./or awareness of the Company's operations and/or intimate knowledge of the
false financial statements filed by the Company with the SFC and disseminated to the
investing public, the Individual Defendants had the power to influence and control
and did influence and control, directly or indirectly, the decision-making of the
Company, including the content and dissemination of the various statements which
Plaintiff contends are false and misleading. The Individual Defendants were provided
with or had. unlimited access to copies of the Company's reports, press releases,
-205-
Case 1:07-cv-02298-BBM Document 35-3 Filed 07/03/2008 Page 60 of 74
public filings and other statements alleged by Plaintiff to be misleading prior to
and/or shortly after these statements were issued and had the ability to prevent the
issuance of the statements or cause the statements to be corrected.
355. In particular, each of these Defendants had direct and supervisory
involvement in the day-to-day operations ofthe Company and, therefore, is presumed
to have had the power to control or influence the particular transactions giving rise
to the securities violations as alleged herein, and exercised the same.
356. As set forth above, NetBank and the Individual Defendants each violated
Section 10(b) and Rule lOb-5 by their acts and omissions as alleged in this
Complaint. By virtue of their positions as controlling persons, the Individual
Defendants are liable pursuant to Section 20(a) of the Exchange Act. As a direct and
proximate result ofDefendants' wrongful conduct, Plaintiff and other members ofthe
Class suffered damages in connection with their purchases of the Company's
securities during the Class Period.
PRAYER FOR RELIEF
WHEREFORE , Plaintiff, on his own behalf and on behalf of the other
members of the Class, demands judgment against the Defendants as follows:
-206-
Case 1:07-cv-02298-BBM Document 35-3 Filed 07/03/2008 Page 61 of 74
A. Determining that this action is properly maintainable as a class action
pursuant to Rule 23 of the Federal Rules of Civil Procedure;
B. Certifying Plaintiff as the representative of the Class and his counsel as
counsel for the Class;
C. Declaring that Defendants violated the federal securities laws by reason
of the wrongful conduct alleged herein;
D. Awarding monetary damages against all Defendants, jointly and
severally, in favor of Plaintiff and the other members of the Class for all losses and
damages suffered as a result of the acts and transactions complained of herein,
together with prejudgment interest from the date of the wrongs to the date of the
judgment herein;
E. Awarding Plaintiff the costs, expenses, and disbursements incurred in
this action, including reasonable attorneys' and experts' fees; and
F. Awarding Plaintiff and the other members of the Class such other and
further relief as the Court may deem just and proper in light of all the circumstances
of this case.
-207-
Case 1:07-cv-02298-BBM Document 35-3 Filed 07/03/2008 Page 62 of 74
JURY TRIAL DEMAND
Plaintiff demands a trial byjury of all claims and issues so triable in this action.
Dated: July 3 , 2008
/s/ Michael J. Gorby! _
Michael J. Gorby, Esq.
Mary Donne Peters, Esq.
GORBV, PETERS &
ASSOCIATES, P.C.
Two Ravinia Drive, Suite 150()
Atlanta, GA 30346-2104
Telephone: (404) 239-1150
Fax: (404) 239-.1179
mgorby@gorbyree-\,-,es.com
mpeters[c gorbyreeves.com
Respectfully submitted,
/s/ Merrill G. Davidoff
Merrill G. Davidoff, Esq.
Michael Dell'Angelo, Esq.
Lane L. Vines, Esq.
BERGER & MONTAGUE, P.C.
1622 Locust Street
Philadelphia, PA 19103
Telephone: (215) 875-3000
Fax: (215) 875-4604
mdavido ffir^,bn1. net
Local Counsel for Lead Plaintiff
Robert A. Brown and the Proposed
Class
Lead Counsel for Lead Plaintiff
Robert A. Brown and the Proposed
Class
-208-
Case 1:07-cv-02298-BBM Document 35-3 Filed 07/03/2008 Page 63 of 74
ATTACHMENT
Case 1:07-cv-02298-BBM Document 35-3 Filed 07/03/2008 Page 64 of 74
IN THE UNITED STATES DISTRICT COURTFOR THE NORTHERN DISTRICT OF GEORGIA
ATLANTA DIVISION
JOHNNY R. ADCOCK,on Behalf of Himself and All OthersSimilarly Situated,
Plaintiff,
V.
NETBANK, INC., STEVEN F. HERBERTand DOUGLAS K. FREEMAN,
Defendants.x
ARASH VAHDAT,on Behalf of Himself and All OthersSimilarly Situated,
Plaintiff,
V.
NETBANK, INC., STEVEN F. HERBERTand DOUGLAS K. FREEMAN,
Defendants.
C.A. No. 1:07-CV-2298-BBM
JURY TRIAL DEMANDED
C.A. No. l:07-CV-2631-BBM
JURY TRIAL DEMANDED
CERTIFICATION OF ROBERT A. BROWN PURSUANT TO THEPRIVATE SECURITIES REFORM ACT OF 1995 "PSLRA"
Robert A. Brown ("Plaintiff'), duly swears and says , as to the claims
asserted under the federal securities laws, that:
1. 1 have reviewed the complaints filed in the litigations captioned
Case 1:07-cv-02298-BBM Document 35-3 Filed 07/03/2008 Page 65 of 74
Adcock v. NetBank, Inc., et al., No. 07-cv-02298-BBM (N.D. Ga.) and Vahdat v.
NetBank, Inc., et al., No. 07-cv-02631-BBM (N.D. Ga.), which alleged violations
of the federal securities laws against NetBank, Inc. ("NetBank" or the "Company")
and several of its officers and directors , including Steven F. Herbert and Douglas
K. Freeman. I have also reviewed a draft complaint that may be filed on my behalf
against NetBank, Inc. and related persons. I approve of its contents, and I
authorize its filing. I authorize Berger & Montague, P.C. to represent me in this
action.
2. 1 did not purchase the security that is the subject of this action at the
direction of my counsel or in order to participate in this private action.
3. I am willing to serve as a representative plaintiff on behalf of the
class, including providing testimony at deposition and trial, if necessary.
4. My transactions in the common stock ofNetBank the relevant class
period March 16, 2005 through and including May 21, 2007 are as follows:
SHARES DATE OFPURCHASED PURCHASE
See attached schedule
SHARES DATE OFSOLD SALE
See attached schedule
PRICE PER
SHARE
PRICE PER
SHARE
2
Case 1 : 07-cv-02298 -BBM Document 35-3 Filed 07/03/2008 Page 66 of 74
5. 1 state that I own and/or control, on behalf of myself and members of
my immediate family, the several investment accounts, listed on the attached
schedule: Robert A. Brown IRA; Robert A. Brown & Judith E. Thomson
JTWROS; Robert A. Brown, Custodian FBO Jared T. Brown; Robert A. Brown,
Custodian FBO Maia T. Brown; and Judith E. Thomson IRA. Ms. Judith Thomson
is my wife. Jared T. Brown and Maia T. Brown are my minor children. At all
times relevant, I had and exercised complete investment control and authority for
all investment transactions in all of the above accounts.
6. In the three years (3) prior to the date of this certification, I have
served as the court-appointed lead plaintiff and class representative in one other
action filed under the United States federal securities laws; that litigation is
captioned Brown v. Kinross Gold U.S.A., Inc., No. CV-S-02-0605-KJD-(RJJ) (D.
Nev.). Specifically, I was appointed by the court in that litigation to serve as one
of the several lead plaintiffs by Order entered August 8, 2002 and as one of the
several class representatives by Order entered June 14, 2005. Other than the above
Kinross litigation, I have not previously sought to serve as a representative party in
an action filed under the United States federal securities laws.
7. 1 have not and will not accept any payment for serving as a
Case 1:07-cv-02298-BBM Document 35-3 Filed 07/03/2008 Page 68 of 74
Type of transaction
Robert A. Brown IRA
Buy
Buy
Buy
Buy
Buy
Buy
Buy
Buy
Buy
Buy
Buy
Buy
Buy
Buy
Buy
Totals
sellSell
Sell
Totals
Net Loss
Robert A . Brown & Judith E. Thomson
Buy
Buy
Buy
Buy
Buy
Buy
Buy
Buy
Buy
Buy
Buy
Buy
Buy
Buy
Buy
Buy
Buy
Buy
ROBERT A. BROWNNETBANK, INC. COMMON STOCKTRANSACTIONAL SUMMARY
Date Shares traded Price uer ShareTotal dollar value of
frarsaction
09-May-2006 45.7778 $6.750 -$309.00
18-May-2006 51.3333 $6.000 -$309.00
23-May-2006 49.6774 $6,200 -$309.00
06-Jun-2006 50.5728 $6.110 -$309.00
13-Jun-2006 49.6774 $6.200 -$309.00
15-Jun-2006 0.3207 $6.049 -$1.94
20-Jun-2006 50.1751 $6.139 -$309.00
02-Feb-2007 114,450.0000 $3.715 -$425,178.70
05-Feb-2007 157,000.0000 $3.705 -$581,681.95
07-Feb-2007 141,318.0000 $3.665 -$517,927.42
28-Feb-2007 458,0000 $3,200 -$1,473.60
06-Mar-2007 998.1618 $2.724 -$2,719.00
13-Mar-2007 100.0000 $2.490 -$257.00
14-Mar-2007 163,446.0000 $2.490 -$406,988.54
27-Mar-2007 98,522.0000 $2.395 -$235,961.14
676,589.6963 -2,174,043.2900
24-May-2007 512,585.6963 $0.390 $195,075.18
24-May-2007 12,800.0000 $0.390 $4,931.71
24-May-2007 151,204.0000 $0,390 $58,208.88
676,589.6963 $ 258,215.77
11-Oct-2005 26.7606 $7.810 -$209.00
18-Oct-2005 27.1429 $7.700 -$209.00
25-Oct-2005 26.4968 $7.888 -$209.00
01-Nov-2005 26.4892 $7.890 -$209.00
08-Nov-2005 27.4151 $7.660 -$210.00
15-Nov-2005 14.0677 37.110 -$100.00
15-Nov-2005 29.4014 $7.110 -$210.00
22-Nov-2005 28.6694 $7.290 -$210.00
06-Dec-2005 28.9041 $7.300 -$211.00
13-Dec-2005 42.3024 $7.210 -$306,00
15-Dec-2005 0,3087 57.839 -$2.42
15-Dec-2005 0.1454 $7.840 -$1.14
20-17ec-2005 42,0110 $7.260 -$306.00
27-Dec-2005 41.5531 $7.340 -$306.00
03-Jan-2006 42.7374 $7.160 -$306.00
10-Jan-2006 40.7210 $7.490 $306.00
17-Jan-2006 41.1611 $7,410 -$306.00
24-Jan-2006 42.3024 $7.210 $306.00
Total Losses
$ -1,915,827.52
Case 1:07-cv-02298-BBM Document 35-3 Filed 07/03/2008 Page 69 of 74
Type of transaction Date Shares traded Price per ShareTota l dollar value of
Total Lossestransaction
Buy 07-Feb-2006 41.0428 $7.480 -$307.00Buy 14-Feb-2006 41.0738 $7.450 -$307.00
Buy 21-Feb-2006 41,3737 $7.396 -$307.00Buy 26-Feb-2006 41.9399 $7.320 -$308.00Buy 07-Mar-2006 42.5414 $7.240 -$308.00Buy 14-Mar-2006 41.9973 $7.310 -$308.00Buy 15-Mar-2006 1.6703 $7.310 -$12.21Buy 21-Mar-2006 40.7324 $7.537 -$308.00
Buy 28-Mar-2006 42.7577 $7.180 -$308.00
Buy 04-Apr-2006 42.7778 $7.200 -$308.00Buy 11-Apr-2006 42.8173 $7.170 -$308.00Buy 18-Apr-2006 42,2289 $7170 -$308.00Buy 25-Apr-2006 44.3642 $6.920 -$308.00
Buy 02-May-2006 44.6377 $6.900 -$308.00Buy 15-Jun-2006 3.5719 $6.050 -$21.61
Buy 21-Feb-2007 500.0000 $3.520 $1,765.95Buy 22-Feb-2047 2,108.0000 $3.600 47,410.57
Buy 27-Feb-2007 2,644.0000 $3.460 -$9,188.85Buy 28-Feb-2007 2,817.0000 $3.250 -$9,198.46Buy 13-Mar-2007 3,764.1801 $2.656 -$10,000.00Buy 13-Mar-2007 100.0000 $2.490 -$257.00Buy 14-Mar-2007 1,800.0000 $2,480 -$4,464.00
Buy 14-Mar-2007 5,944.0000 $2,485 -$14,778.84
Buy 14-Mar-2007 25,500.0000 $2,490 -$63,495.00Buy 20-Mar-2007 4,462.5000 $2,240 410,000.04Buy 22-Mar-2007 18,173.0000 $2.170 -$39,708.96
Buy 22-Mar-2007 418.0000 $2.350 -$996.25
Buy 23-Mar-2007 7,398.0000 $2.340 417,423.24
Buy 23-Mar-2007 3,400.0000 $2.410 -$8,245.95Buy 26-Mar-2007 21,617.0000 $2.390 -$51,660.58Buy 27-Mar-2007 28,612.0000 $2,390 -$68,812.81
Buy 24-Apr-2007 3,249.2537 $2.010 46,535.00
Totals 133591.0506 $331,920.84
Sell 22-May-2007 100,247.0506 $0.373 $36,469.96
Sell 24-May-2007 33,344.0000 $0.390 $12,834.01
Totals 133,591.0506 $49,303.97
Not Loss $ -295,450.88
Robert A. Brown. Custodian FBO Jared T. Brown
Buy 06-Mar-2007 156.2500 $2.720 $429.00
Buy 27-Mat-2007 2,289.5833 $2.400 -$5,499.00
Totals 2,445.8333 -$5,928.00
Sell 22-May-2007 2,445.8333 $0.566 $1,384.34
Net Loss $ -4.543.66
Case 1:07-cv-02298-BBM Document 35-3 Filed 07/03/2008 Page 70 of 74
Type of transaction ate Shares traded Price per ShareTotal dollar value of
transaction
Robert A . Brown, Custodian FBO Maia 7 Brown
Buy 10-Apr-2007 3,013.4805 $1,780 -$5,367.00
Sell 22-May-2007 3,013.4805 $0.568 $1,705.63
Net Loss
Judith E. Thomson IRA
Buy 27-Jun-2006 57.1205 $6.390 -$365.00
Buy 05-Jul-2006 58.2137 $6.271) -$365.00
Buy 11-Jul-2006 55.9140 $6.510 -$365.00
Buy 18-Jul-2006 58.6161 $8.210 -$365.00
Buy 25-Jul-2006 57.8862 36.310 -$365.00
Buy 01-Aug-2006 69.3916 35.260 -$365.00
Buy 08-Aug-2006 86.6667 $4.200 -$365.00
Buy 15-Aug-2006 66.2059 35.498 -$365.00
Buy 22-Aug-2006 67.6580 $5.380 -$365.00
Buy 05-Sep-2006 62.3942 35.850 -$365.00Buy 12-Sep-2006 59.8684 $6.080 -$365.00
Buy 19-Sep-2006 61.3828 35.930 -$365.00
Buy 26-Sep-2006 60.06660 36.060 -$365.00
Buy 03-Oct-2006 60,6312 $6.020 -$365.00
Buy 10-Oct-2006 58.2400 36.250 -$365.00
Buy 17-Oct-2006 60.6667 $6.000 -$365.00
Buy 24-Oct-2006 63.2054 $5.759 -$365.00Buy 07-Nov-2006 66.7276 $5.470 -$365.00
Buy 14-Nov-2006 68.6792 $5.300 -$365.00
Buy 21-Nov-2006 69.5985 $5230 -$365.00
Buy 28-Nov-2006 75.5579 $4.818 -$365.00
Buy 05-Dec-2006 78.3262 $4.660 -$365.00
Buy 12-Dec-2006 77.4468 $4.700 4365.00
Buy 19-Deo-2006 86.5225 $4.207 -$365.00Buy 26-11^-2006 79.6499 $4.570 -$365.00
Buy 03-Jan-2007 842956 $4.330 -$385.00
Buy 09-Jan-2007 89.8765 $4.050 -$365.00
Buy 16-Jan-2007 88.9976 $4.090 -$365.00
Buy 23-Jan-2007 94.5595 $3.860 -$366.00
Buy 06-Feb-2007 97.6000 $3.750 -$366.00Buy 08-Feb-2007 14,200.0000 $3.580 -$51,045.95
Buy 14-Feb-2007 73,472.0000 $3.580 -$264,128.79Buy 28-Feb-2007 520.0000 $3.200 -$1,672.00
Buy 06-Mar-2007 429.0441 $2,720 -$1,171.00
Buy 14-Mar-2007 72,685.0000 $2.480 -$180,266.80
Buy 16-Mar-2007 11,692.0000 $2.480 -$29,004.16Buy 27-Mar-2007 6,033.0000 $2.380 -$14,449.99Buy 28-Mar-2007 78,651.0000 $2.380 -$188,370.10
Totals 259,8Q3.8094 -$741,060.79
Total Losses
$ -3,661.37
Case 1:07-cv-02298-BBM Document 35-3 Filed 07/03/2008 Page 71 of 74
Type of transaction Date Shares traded Price per Share
Sell 24-May-2007 174,9M.8094 $0.390Sell 24-May-2007 84,897.0000 $0.390
Totals 259,803.8094
Net Loss
TOTAL SHARES 1,075,443.8701
TOTAL NET LOSS
Total dollar value oftransaction
$66,507.28
$32,680.90
$99,188.18
Total Losses
$ -674,553.51
$ -2,894,036.94
Case 1 : 07-cv-02298 -BBM Document 35-3 Filed 07/03/2008 Page 72 of 74
IN THE UNITED STATES DISTRICT COURT
FOR THE NORTHERN DISTRICT OF GEORGIAATLANTA DIVISION
Civil Action No . 1:07-cv-2298
IN RE NETBANK, INC.SECURITIES LITIGATION Jury Trial Demanded
CERTIFICATION
Submitting Counsel hereby certifies that the text of the foregoing document
has been prepared with Times New Roman 14 point, one of the fonts and point
selections approved by the Court, and complies in all respects with Local Rule
5.1(C) of the United States District Court, Northern District of Georgia.
Dated : July 3 , 2008
Isf Michael J. GorbyMichael J. Gorby, Esq.Mary Donne Peters, Esq.GORBY, PETERS &ASSOCIATES, P.C.
Two Ravinia Drive, Suite 1500Atlanta, GA 30346-2104Telephone: (404) 239-1150Fax: (404) [email protected]@gorbyreeves.com
Is/ Merrill G. DavidoffMerrill G. Davidoff, Esq.Michael Dell'Angelo, Esq.Lane L. Vines, Esq.
BERGER & MONTAGUE, P.C.1622 Locust StreetPhiladelphia, PA 19103Telephone: (215) 875-3000Fax: (215) [email protected]@[email protected]
Local Counselfor Lead PlaintiffRobert A. Brown and the ProposedClass
Lead Counselfop Lead PlaintiffRobert A. Brown and the Proposed
Class
Case 1 : 07-cv-02298 -BBM Document 35-3 Filed 07/03/2008 Page 73 of 74
IN THE UNITED STATES DISTRICT COURT
FOR THE NORTHERN DISTRICT OF GEORGIAATLANTA DIVISION
Civil Action No. 1:07-cv-2298IN RE NETBANK, INC.SECURITIES LITIGATION
Jury Trial Demanded
CERTIFICATE OF SERVICE
This is to certify that I have this day served counsel for all parties in the
foregoing matter with a copy of CONSOLIDATED AND AMENDED CLASS
ACTION COMPLAINT with the Clerk of Court using the CM/ECF system,
which will automatically send email notification of such filing to the following
counsel of record:
Michael R. Smith, Esq.Benjamin Lee, Esq.KING & SPALDING LLP1180 Peachtree Street, N.E.Atlanta, Georgia 30309-3521(404) 572-4600(404) 572-5100 Faxmrsmith kslaw.comblee(kslaw.com
Attorneysfor Defendants
Case 1:07-cv-02298-BBM Document 35-3 Filed 07/03/2008 Page 74 of 74
This 3rd day of July, 2008.
/s/ Michael J. Gorby
Michael J. Gorby, Esq.
Mary Donne Peters, Esq.
GORBY, PETERS &
ASSOCIATES, P.C.Two Ravinia Drive, Suite 1500Atlanta, GA 30346-2104Telephone: (404) 239-1150Fax: (404) [email protected]@gorbyreeves.com
Is/ Merrill G. DavidoffMerrill G. Davidoff, Esq.Michael Dell'Angelo, Esq.Lane L. Vines, Esq.BERGER & MONTAGUE, P.C.1622 Locust StreetPhiladelphia, PA 1.9103Telephone: (215) 875-3000Fax: (215) [email protected]@[email protected]
Local Counselfor Lead Plaintiff Lead Counselfor Lead PlaintiffRobert A. Brown and the Proposed Robert A. Brown and the ProposedClass Class