The $1 billion lawsuit filed last week against First Magnus’ executives is filled with wild and outlandish allegations, former First Magnus Vice Chairman Thomas Sullivan Jr. said.

During an hour-long meeting Thursday at First Magnus’ former headquarters — which is now leased to StoneWater Mortgage, a company started and run by former First Magnus executives — Sullivan denied any wrongdoing and said no one saw the company’s collapse coming.

But he declined to answer a number of questions about First Magnus’ operations, saying they will be answered in court. Questions were also e-mailed to former First Magnus executive Karl Young, who had not responded late Friday.

“If (former Federal Reserve chairman) Alan Greenspan has gone on record to say that nobody knew this was happening, how could a small company in Tucson, Arizona, know more than Alan Greenspan?” Sullivan said. “The only reason that we went out of business is that the secondary market collapsed.”

The 200-page suit says First Magnus executives knew the company was a sinking ship, possibly as early as 2005, and looted it for hundreds of millions of dollars in the form of bonuses and stock redemptions. First Magnus’ officers and directors based these bonuses and redemptions on false revenues, the suit alleges, because the company did not place funds in reserve to cover defaulting loans it generated.

First Magnus executives then founded StoneWater Mortgage, relying on computer software and technology that belonged to First Magnus, the suit claims.

“Having failed to adequately reserve or account for contingencies, the directors and officers devised an exit strategy for themselves — make as many loans as possible with other people’s money and cash-out before the house of cards comes tumbling down,” the suit says.

Sullivan declined to answer questions about reserves or when First Magnus’ officers and directors knew the company was heading for bankruptcy, saying those questions will be answered in court.

But he said the software StoneWater is using to generate loans — he is an investor in StoneWater — is unique because it was designed for a “centralized” office, whereas First Magnus’ software was designed for “decentralized” offices.

“Separate software. Separate companies,” he said. “Developed on its own. The only similarity is that it’s mortgage software.”

Risky business

The majority of the loans First Magnus created were Alt-A quality, meaning they were riskier than prime loans made to borrowers with excellent credit but not as risky as subprime loans made to borrowers with poor credit or insufficient resources to pay back the loans.

Between January 2005 and its bankruptcy filing, First Magnus sold more than $70 billion in loans to investors, the complaint says.

Those purchase agreements came with indemnities, meaning First Magnus would repurchase the loans if they became delinquent.

But the suit claims First Magnus officials never set aside reserve funds for the more than $70 billion in loans, and it carried only $400,000 to back up the roughly $2 billion in loans it had for sale at any given time.

Alt-A loans may not be safe as prime loans, but Sullivan said not generating them during the housing boom would have been akin to a company like Wal-Mart choosing not to sell its hottest product.

“The Alt-A product became the overwhelming choice of borrowers, consumers and builders,” Sullivan said.

First Magnus’ sudden closure and bankruptcy in 2007 left 5,500 people nationwide and in Tucson without jobs and about $13 million in nationwide wage claims.

Claims of corporate looting

The suit accuses First Magnus of fueling the financial crisis, which Sullivan called “absurd.”

While that is an eye-catching claim, University of Arizona law professor Jean Braucher said the real question is whether First Magnus’ officers and directors engaged in corporate looting.

“To some extent this idea that they were a big player in causing the financial crisis isn’t really essential to the lawsuit,” Braucher said. “If they can prove all these transfers happened while they were insolvent, the rest of it doesn’t really matter. I think there are a lot of allegations that they engaged in lending practices that weren’t prudent and misrepresented, sort of, the degree of risk in these transactions.

“But what is different in this case is not only did they do that, but that when this business was collapsing they (allegedly) took all of these assets out for these insiders in a very deliberate way over time.”

Sullivan would not respond to the allegation the company transferred money while insolvent.

Dan Schecter, a professor with Loyola Law School in Los Angeles, said one potential defense First Magnus executives might pursue is that they were unaware of the consequences of their business decisions, which were made in good faith.
That argument, Schecter said, would go something along the lines of “we were simply exercising our business judgment. We were just doing our normal job. This is customary behavior.”

The case will almost certainly be heard before a bankruptcy judge, but there is a possibility that it could end up before a jury. That’s very unlikely, but “the threat of a jury simply increases the settlement value of the case,” Schecter said.

Jamie R. Welton, the attorney representing the trustees, said it is his preference the case stay before a bankruptcy judge.

The Sullivan redemption

Key to the suit are questions about a $55 million stock redemption to Thomas Sullivan Sr., one of First Magnus’ founders, in August 2006.

The redemption “decimated” First Magnus’ “working capital and left it with woefully inadequate reserves necessary” to handle its obligations for defaulting loans, the suit says.

The younger Sullivan would not talk about stock redemption or bonuses.
To address the shortage in capital, First Magnus’ parent company set up a revolving line of credit that grew to $60 million between the parent company and First Magnus. The suit alleges the directors and officers used this line of credit to move funds back and forth between the two entities, keeping First Magnus going while ultimately moving funds out of the company as bankruptcy drew near.

For example, on June 30, 2007, just weeks before the bankruptcy filing, First Magnus made a $24.8 million payment to its parent company, the suit says.
“One of the things that really bothered me is that they are the directors and officers” of both companies, Welton said. “They have up to $60 million First Magnus can draw on. Instead of paying the employees in full before they file for bankruptcy, they pay themselves.”

The younger Sullivan said the company would answer all allegations in court. First Magnus’ officers were from Tucson, were invested in the community and wouldn’t have done anything to hurt the town where they lived and worked, he said.

Credits: Arizona Daily Star

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