Suit Based on U.S. GAAP Proceeds

Popular Inc. looses its plea to dismiss a class-action securities suit involving the alleged improper booking of deferred tax assets.
Robert WillensAugust 30, 2010

Earlier this month, a U.S. District Court in Puerto Rico rendered an opinion largely against the banking firm of Popular Inc.1 At issue was whether the bank, a publicly traded bank-holding company headquartered in Puerto Rico, violated U.S. generally accepted accounting principles with respect to booking deferred tax assets, and did not fully disclose that its U.S. subsidiary, Banco Popular North America Inc., was undercapitalized. (BPNA operates online consumer mortgage and loan company E-LOAN and third-party subprime loan originator Equity One, among other companies. Popular also operates Banco Popular de Puerto Rico.)

The plaintiffs launching the class-action lawsuit against the bank purchased or acquired Popular common stock and/or Series B Monthly Income Preferred Stock between January 24, 2008, and February 19, 2009 (the class period). The company and its co-defendants, which include the bank’s CEO and CFO, moved to have the plaintiffs’ complaint dismissed. The court refused, in large part, to accede to this request.

At the beginning of the class period, Popular was in a three-year cumulative loss position. Specifically, it had a cumulative loss of $465 million for the years ending December 31, 2005, through December 31, 2007. Since before the start of the class period, Popular reported its losses at Popular US as DTA without recording a valuation allowance against them.

Drive Business Strategy and Growth

Drive Business Strategy and Growth

Learn how NetSuite Financial Management allows you to quickly and easily model what-if scenarios and generate reports.

Then, on October 22, 2008, Popular announced that “due to its three-year cumulative loss position,” it was required to record a partial valuation allowance against its DTAs. Later, on January 22, 2009, Popular revealed the need to record a full valuation allowance against the DTAs.

In response, the plaintiffs lodged the following charges against Popular: (1) under U.S. GAAP, Popular’s three-year cumulative loss position and the downsizing of its U.S. mainland operations required the corporation to record a full valuation allowance against its DTAs; (2) the corporation’s increasing losses should have prevented it from anticipating sufficient taxable income to realize its DTAs prior to the 20-year expiration period; (3) under GAAP, the corporation’s “tax strategies” (the execution of which would produce taxable income) were neither prudent, feasible, nor otherwise sufficient; and (4) Popular was not “well-capitalized” because recording the required full valuation allowance would have lowered its risk-based capital ratio well below the 10% requirement.

Willens 08-30-2010.gif

The essential elements of the claim were brought under Section 10(b) and Rule 10b-5 of the Securities Exchange Act of 1934. Essentially, the plaintiffs charged Popular as materially misrepresenting or omitting — with scienter — investors with respect to the purchase or sale of securities. (Scienter is a mental state embracing intent to deceive, manipulate, or defraud.) The plaintiffs’ theory of “material falsity” was premised on the allegation that Popular should have recorded a full valuation allowance several months before it did, and that in not doing so, the bank misapplied GAAP. The court, while not passing on the merits of this claim, ruled that the complaint should not be dismissed.

More Likely Than Not

Under the accounting rule known as Topic 740 (formerly FAS 109, Accounting for Income Taxes, ASC 730), DTAs may only be maintained on a corporation’s balance sheet when it is expected that they will be realized. That is, a valuation allowance should be taken if, based on the weight of available evidence, “it is more likely than not…that some portion or all of the DTAs will not be realized.”

Topic 740 indicates that it is difficult to conclude that a valuation allowance is not necessary in certain circumstances, such as when there is negative evidence. That includes when a company records cumulative losses in recent years or if there is evidence of “unsettled circumstances” that, if not resolved, would adversely affect operations or profits in the future.

The court concluded that the allegations in this case were adequate to plead that Popular’s financial statements were materially misstated. In fact, the courted stated that a reasonable inference may be drawn that Popular’s cumulative loss position, combined with the company’s downsizing of its mainland operations and the worsening market conditions, constituted “strong evidence” that, at the beginning of the class period, it was more likely than not that the company would not be able to realize the benefits of its DTAs in full. The court also concluded that the plantiffs’ falsity claim is supported by several alleged facts and reasonable inferences drawn from those facts — most importantly, Popular’s cumulative losses over the preceding three years. As a result, the defendants’ motion to dismiss the plaintiffs’ claim on this ground was denied.

It was also necessary for the plaintiff to demonstrate scienter.2 A plaintiff, the court noted, can demonstrate scienter by showing that defendants either consciously intended to defraud or that they acted with a “high degree of recklessness.” The court concluded that the plaintiffs’ allegations regarding Popular’s scienter were sufficient to meet the relevant pleading standards. In addition, the court found that the bank’s decision not to take an earlier valuation allowance was “highly unreasonable” and an “extreme departure from the standards of ordinary care.” Therefore, the motion to dismiss on this ground, the absence of scienter, was also denied.

Forward-Looking Statements

Often, courts have declined to impose liability for forward-looking statements because such statements are unlikely, as a matter of law, to be material to a reasonable investor. In the Popular case, the defendants contended that the statements relied upon by the plaintiffs for their allegations of securities fraud constituted forward-looking statements. The court disagreed. It noted that the forward-looking statements were not accompanied by “meaningful cautionary statements.” Moreover, the maker of the statements had actual knowledge that they were false or misleading. Therefore, neither safe harbor for forward-looking statements was satisfied. Accordingly, the motion to dismiss on this ground was also denied.

As a result of the Popular decision, a claim of securities fraud based on a belated recordation of a valuation allowance can proceed to trial. Whether securities fraud was, in fact, committed will have to await the next phase of the litigation. Presumably, the failure to record any valuation allowance at all, where it is later determined that one was necessary, would be an easier case for a court to advance toward resolution.

Contributor Robert Willens, founder and principal of Robert Willens LLC, writes a weekly tax column for 


1 Russell Hoff et al. v. Popular, Inc. et al., _F.Supp.2d_ (DC P.R. 2010).

2 See Ernst & Ernst v. Hochfelder, 423 US 185 (1976).