Exhibit 99.3
UNITED STATES OF AMERICA
BEFORE THE
SECURITIES AND EXCHANGE COMMISSION
SECURITIES ACT OF 1933
Release No.
SECURITIES EXCHANGE ACT OF 1934
Release No.
Accounting and Auditing Enforcement
Release No.
ADMINISTRATIVE PROCEEDING
File No.
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:
In the Matter of :
: ORDER INSTITUTING
THE PNC FINANCIAL SERVICES : PUBLIC
GROUP, INC., : ADMINISTRATIVE
: PROCEEDINGS
: PURSUANT TO
Respondent : SECTION 8A OF THE
: SECURITIES ACT OF 1933 AND
: SECTION 21C OF THE
: SECURITIES EXCHANGE
: ACT OF 1934,
: MAKING FINDINGS
: AND IMPOSING CEASE
: AND DESIST ORDER
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I.
The Securities and Exchange Commission ("Commission") deems it
appropriate that public administrative proceedings be, and hereby are,
instituted pursuant to Section 8A of the Securities Act of 1933 ("Securities
Act") and Section 21C of the Securities Exchange Act of 1934 (the "Exchange
Act") to determine whether The PNC Financial Services Group, Inc., Pittsburgh,
Pennsylvania, a bank holding company ("PNC"), violated or caused violations of
Sections 17(a)(2) and 17(a)(3) of the Securities Act, Sections 10(b), 13(a) and
13(b)(2)(A) of the Exchange Act and Exchange Act Rules 10b-5, 12b-20, 13a-1 and
13a-13.
II.
In anticipation of the institution of these administrative proceedings,
PNC has submitted to the Commission an Offer of Settlement of The PNC Financial
Services Group, Inc. ("Offer") that the Commission has determined to accept.
Solely for the purposes of these proceedings, and for any other
proceeding brought by or on behalf of the Commission, or to which the Commission
is a party, and without admitting or denying the findings set forth below,
except as to the jurisdiction of the Commission over it and over the subject
matter of these proceedings, which PNC admits, PNC consents to the entry by the
Commission of the Order Instituting Public Administrative Proceedings Pursuant
to Section 8A of the Securities Act of 1933 and Section 21C of the Exchange Act
of 1934, Making Findings and Imposing Cease-and-Desist Order (the "Commission
Order"). The Commission has determined that it is appropriate to accept the
Offer and accordingly is issuing this Commission Order.
III.
Accordingly, IT IS HEREBY ORDERED, that administrative proceedings
pursuant to Section 8A of the Securities Act and Section 21C of the Exchange Act
be, and they hereby are, instituted.
IV.
COMMISSION FINDINGS
On the basis of the Commission Order and PNC's Offer, the Commission
finds that:
A. SUMMARY
In 2001, PNC endeavored to remove certain loans and venture capital
investments from its financial statements by transferring them to certain
entities that were specially created to receive these assets and in which PNC
held a substantial interest. PNC made these transfers in order to reduce its
exposure to loan losses and venture capital investment losses. PNC intended that
the entities receiving these assets be regarded as "special purpose entities"
under generally accepted accounting principles ("GAAP") that would not have to
be consolidated with PNC. For the second and third quarters of 2001, PNC filed
regulatory reports and financial statements with the Board of Governors of the
Federal Reserve System ("Board") and with the Commission that did not
consolidate these entities. PNC also made statements in its filings with the
Commission and in certain press releases that described a strategy of
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turning its corporate focus away from commercial lending, and reducing its loan
exposure.
PNC's accounting with respect to these entities was improper under
GAAP, and PNC made materially false and misleading disclosures in its filings
with the Commission and in press releases about its financial condition and
performance, including, among other things, a material overstatement of its 2001
earnings. PNC's failure to account properly for these transactions, and its
false and misleading disclosures, created a materially inaccurate picture that
it was reducing its exposure to commercial lending and venture capital
activities, and the risks attendant thereto, when in fact it remained exposed to
the risks presented by the assets transferred to the special purpose entities.
Further, PNC's books and records were inaccurately maintained in connection with
these transactions. Accordingly, PNC violated the financial reporting,
recordkeeping and antifraud provisions of the federal securities laws.
B. RESPONDENT
The PNC Financial Services Group, Inc. is a Pennsylvania corporation,
with its principal place of business in Pittsburgh, Pennsylvania. PNC is a bank
holding company and is the holding company for PNC Bank, National Association
("PNC Bank") and other bank and nonbank subsidiaries. PNC operates community
banking, corporate banking, real estate finance, asset-based lending, wealth
management, asset management and global fund services businesses. PNC's primary
geographic markets are in Pennsylvania, New Jersey, Delaware, Ohio and Kentucky.
Certain of PNC's securities are registered with the Commission pursuant to
Section 12(b) of the Exchange Act and listed on the New York Stock Exchange.
C. FACTS
1. STRUCTURE AND ACCOUNTING TREATMENT OF SPECIAL PURPOSE ENTITY
TRANSACTIONS
During 2001, PNC entered into three transactions (each a "PAGIC
transaction") intended to transfer certain loans and venture capital assets from
its balance sheet to other entities (each a "PAGIC entity"). These transactions
were sponsored by an insurance company. Each PAGIC transaction involved the
creation of two limited liability companies, one of which sold a substantial
ownership interest to PNC and a minority ownership interest to the insurance
company. With funds received in exchange for its shares, each PAGIC entity
purchased loans or venture capital assets from PNC; some assets were acquired
directly in exchange for shares. Many of the loans and assets transferred by PNC
were volatile, troubled or nonperforming.
In each of the second, third and fourth quarters of 2001, PNC entered
into a PAGIC transaction. In its original regulatory and financial reports filed
with the Board
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and the Commission for the second and third quarters of 2001, PNC treated the
loans and other assets transferred to PAGIC entities as if they were no longer
assets of PNC, that is, no longer held anywhere within PNC, as a consolidated
bank holding company. PNC intended that, as a result of the PAGIC transactions,
PNC's balance sheet would reflect a reduction in exposure to troubled loans and
volatile assets. PNC also intended, as a result of the PAGIC transactions, not
to charge losses on the loans and other assets transferred to the PAGIC entities
against its income. In addition, the PAGIC transactions were structured to allow
PNC to benefit over a period of time from any improvement in the value of the
transferred assets. Thus, the PAGIC transactions were an effort to eliminate
PNC's risk of loss on the transferred loans and other assets, while allowing it
to benefit from any long-term improvement in their values. Had PNC continued to
include these transferred assets in its financial statements, it would have been
required to reflect in its financial statements any losses incurred and the
benefit of any improvement in the value of these assets.
In sum, PNC transferred a total of approximately $762 million in loan
and venture capital assets to the PAGIC entities, and PNC received preferred
stock from the three PAGIC entities in exchange. PNC continued to service the
loans and other assets transferred to the PAGIC entities. A substantial portion
of the loans and other assets were volatile, troubled or nonperforming, and PNC
would otherwise have had to evaluate them periodically and potentially re-value
them with consequent effects on PNC's earnings.
The PAGIC entities were specifically created for the purposes of the
PAGIC transactions and were intended to be treated by PNC as off-balance sheet
"special purpose entities" under GAAP. PNC's ability under GAAP to account for
its financial condition as if it no longer owned the assets transferred to the
PAGIC entities depended upon whether or not the transactions complied with the
GAAP requirements for nonconsolidation of special purpose entities. As is
discussed in greater detail below, at the times PNC entered into the PAGIC
transactions, GAAP required that an independent third party be the majority
owner of each PAGIC entity, that the independent third party provide a
substantive capital investment in and have control of the PAGIC entity, and that
the majority owner have substantive risks and rewards of ownership of the PAGIC
entity.
In fact, none of the PAGIC transactions complied with these GAAP
requirements for nonconsolidation of special purpose entities. Therefore, PNC's
second and third quarter 2001 regulatory reports and financial statements were
not presented in conformity with GAAP. In short, PNC improperly treated the
transfers of assets to the PAGIC entities as sales, when it should have
consolidated the assets of the PAGIC entities in its regulatory reports and
financial statements. This failure to consolidate resulted, among other things,
in (a) a material overstatement of PNC's earnings per share for the third
quarter of 2001 by 21.4%, (b) a material understatement of PNC's fourth quarter
2001 loss per share of 25% in a press release, (c) material understatements
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of the amounts of PNC's nonperforming loans and nonperforming assets, and (d)
material overstatements of the amounts of reductions in loans held for sale and
overstatements in the amounts of securities available for sale. A further
consequence of PNC's improper accounting was that PNC materially overstated 2001
earnings per share in a press release issued on January 17, 2002 by 52%.
In connection with its improper accounting, PNC also made materially
false and misleading disclosures in certain press releases and in Forms 10-Q
filed with the Commission for the second and third quarters of 2001, concerning
aspects of its financial condition affected by the PAGIC transactions. These
disclosures created a picture that materially overstated the extent to which PNC
was moving its corporate focus away from commercial lending and reducing its
exposure to the risks attendant to commercial lending and venture capital
activities. In early 2002, PNC decided to restate its financial statements for
the second and third quarters of 2001, and to revise its earnings for the fourth
quarter of and full year 2001. PNC thereafter filed amended Forms 10-Q for the
second and third quarters of 2001, and a Form 10-K for 2001.
2. PAGIC I
In the first PAGIC transaction ("PAGIC I"), which closed on June 28,
2001,(1) the insurance company, through a subsidiary, organized the special
purpose entity as a Delaware limited liability company ("PAGIC I LLC"). At
closing, the insurance company received $36,576 of PAGIC I LLC's Class B common
stock and $11,558,940 of its Class B preferred stock in exchange for a cash
contribution of $11,595,517. PNC, through a nonbank subsidiary, contributed
$365.8 million in cash to PAGIC I LLC and received $365.8 million of Class A
preferred stock.
PNC's Class A preferred stock was noncumulative, nonvoting, and
convertible, and was mandatorily redeemable at its face amount of $365.8 million
in 30 years. No Class A common stock was issued at the closing of PAGIC I, but
PNC could convert its Class A preferred stock at any time into Class A common
stock. The Class A common stock, if issued, would confer on PNC 99.99% of the
common shares, but those Class A common shares could only be voted to cause an
orderly liquidation of PAGIC I LLC.
The cash contributed by the insurance company to PAGIC I LLC in
exchange for shares was used to purchase investment grade assets, primarily
bonds. The insurance company's Class B preferred stock was entitled to a
variable dividend, which consisted of the cash earnings of the investment grade
securities purchased with the insurance company's contribution. If PNC converted
its Class A preferred stock to Class A common stock and then voted to liquidate
PAGIC I LLC, the insurance company's Class B preferred stock was entitled to a
liquidation preference up to $11,463,424.
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(1) PAGIC I was the prototype for the two subsequent PAGIC transactions.
Although there were some minor variations in the deals, the terms and the
accounting results were essentially the same.
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The insurance company's Class B common stock purported to give it
control over the affairs of PAGIC I LLC (except for a decision to liquidate
PAGIC I LLC once PNC converted its Class A preferred stock to Class A common
stock), including among other things the authority to decide whether or not to
declare dividends on the Class A preferred stock held by PNC. The insurance
company could not liquidate PAGIC I LLC during the first five years of its
existence, except with PNC's consent. PNC, on the other hand, could cause a
liquidation of PAGIC I LLC at any time, and without penalty after five years, by
converting its Class A preferred stock to Class A common stock and voting this
common stock in favor of liquidation.
PNC's cash contribution to PAGIC I LLC was used as follows: (a)
approximately $285 million was used to purchase troubled commercial loans and
unfunded commitments from PNC Bank, (b) approximately $78 million was used to
purchase a zero-coupon U.S. Treasury security that would mature in 30 years in
its face amount of $365 million, and (c) approximately $3 million was used as an
expense account and to pay a $2.7 million management fee to the insurance
company at the closing of PAGIC I. While the Class A preferred stock held by PNC
bore a dividend, that dividend was noncumulative, had to be paid from the cash
(if any) derived from the loans held by PAGIC I LLC, and was payable only if
there were sufficient funds available after, among other things, the annual
payment of the management fee to the insurance company, and then only if the
insurance company declared dividends on it. If the loans PNC had transferred to
PAGIC I LLC improved in value, PNC could recapture the benefit of that
improvement by converting its Class A preferred stock to Class A common stock
and voting to liquidate PAGIC I LLC.2
PAGIC I LLC was required to pay the insurance company a management fee
of approximately $2.7 million per year for the first five years of PAGIC I LLC's
existence, and 75 basis points (i.e., 0.75%) of the total assets of PAGIC I LLC
(excluding the investment grade securities underlying the insurance company's
Class B preferred) per year thereafter. As legally required by the closing
documents for PAGIC I, PAGIC I LLC paid the insurance company the first year's
management fee in advance, on the date of closing of PAGIC I, June 28, 2001. In
addition to the up-front management fee for the first year, PAGIC I LLC was
obligated to pay at the beginning of each of the succeeding four years to the
insurance company an annual management fee equal to the amount of the up-front
fee. This feature of the transaction enabled the insurance company to receive
back more than the amount of its initial capital investment within four years.
Although a subsidiary of the insurance company was the managing member
of PAGIC I LLC, the insurance company's involvement in the business and
management
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2 In a PNC-triggered liquidation, the insurance company would receive up to
$11,463,424. PNC would hold only Class A common stock and would receive
99.99% of the residual value of PAGIC I LLC, including the increased value
of the loans it had transferred to PAGIC I LLC. During the existence of
PAGIC I LLC, PNC had a right of first refusal as to any loans that PAGIC I
LLC sold.
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of PAGIC I LLC was mostly passive. PNC Bank, PNC's principal banking
subsidiary, serviced the loans transferred to PAGIC I LLC for a loan servicing
fee of 50 basis points (i.e., 0.5%) of the aggregate loan amounts, or
approximately $1.5 million per year. PNC Bank retained the relevant loan records
and established bank accounts for loan collections. As the loan servicer, PNC
Bank received payments, was responsible for valuing the loans on an annual
basis, and developed action plans for managing the workout of the loans. The
insurance company's actual management of PAGIC I LLC was limited, at best.
PAGIC I LLC's initial structure immediately after closing was as
follows:
PAGIC I LLC'S INITIAL STRUCTURE
ASSETS EQUITY
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$11,595,517 investment grade securities $365,800,000 Class A Pref. (PNC)
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$284,531,570 commercial loans (unfunded $11,558,940 Class B Pref. (Ins. Co.)
commitments and principal)
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$78,425,539 30-yr. zero-coupon Treasury $36,576 common (Ins. Co.)
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$2,842,891 (cash used to pay management
fee and expenses)
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$377,395,516 TOTAL $377,395,516 TOTAL
On its financial statements, PNC recorded the Class A preferred stock
received from PAGIC I LLC as debt securities available for sale, while removing
from the loan portfolio of PNC Bank the loans that were transferred to PAGIC I
LLC.
PNC intended that the structure of the PAGIC I transaction would allow
it not to recognize losses from the loans and other assets it had transferred to
PAGIC I LLC. PNC understood that, had those loans remained on its books, it
would have had to recognize such losses in its earnings.
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3. PAGICS II AND III
On September 27, 2001 and November 30, 2001, PNC entered into similar
transactions ("PAGIC II" and "PAGIC III") with two other special purpose
entities ("PAGIC II LLC" and "PAGIC III LLC"). These two special purposes
entities were also established by a subsidiary of the insurance company and
issued shares in exchange for contributions.
In PAGIC II, PAGIC II LLC received from PNC Bank a total of
$538,816,528: $326,896,933 in loans and $211,919,595 in cash. In exchange, PAGIC
II LLC issued to PNC Bank shares of Class A preferred stock in PAGIC II LLC. PNC
Bank immediately assigned these shares to the same nonbank subsidiary of PNC
that held shares of PAGIC I LLC, and the shares were maintained on PNC's books
as debt securities available for sale. The terms of the Class A preferred stock
in PAGIC II LLC were very similar to the terms of the PAGIC I LLC Class A
preferred, and PNC Bank entered into an agreement to continue to service the
transferred loans. The cash contribution was used to cover unfunded commitments
and letters of credit with respect to the loans ($89,493,162), the purchase of a
zero-coupon Treasury bond ($118,493,760), expenses, and the first year's
management fee ($3,682,672, payable at closing to the insurance company).
The insurance company contributed $16,918,904 in cash to PAGIC II LLC
and received Class B common stock and Class B preferred stock, which had terms
very similar to those of the PAGIC I LLC Class B stock. PAGIC II LLC used the
insurance company's cash contribution to purchase investment grade securities.
The insurance company was the managing member of PAGIC II LLC, and PAGIC II LLC
was required to pay the insurance company a management fee at the closing and
periodically thereafter.
In PAGIC III, PNC nonbank subsidiaries contributed approximately $252
million in cash and equity assets (including venture capital investments and
related commitments) to PAGIC III LLC in exchange for Class A preferred stock.
PNC recorded the Class A shares as debt securities available for sale. A nonbank
subsidiary of PNC was retained to service the venture capital assets. PNC's cash
contribution was used to cover certain unfunded commitments, to purchase a
Treasury zero-coupon bond, and to cover expenses, including the first year's
management fee of $1,716,950 payable at closing to the insurance company. PAGIC
III LLC also purchased a guaranteed investment contract from the insurance
company, which could be drawn upon to satisfy unfunded commitments.
The insurance company contributed $8,021,417 in cash to PAGIC III LLC
in exchange for Class B common and preferred stock. The cash contribution was
used to purchase investment grade securities, as in PAGICs I and II. As in the
earlier PAGIC transactions, the insurance company was the managing member of
PAGIC III LLC, and
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PAGIC III LLC was required to pay the insurance company a management fee at the
closing and periodically thereafter.
4. PNC'S FORM 10-Q FOR THE QUARTER ENDED JUNE 30, 2001
In a Form 10-Q filed with the Commission on August 14, 2001, PNC
disclosed its financial performance and financial condition for the second
quarter of 2001. PNC did not include on its balance sheet, as set forth in this
Form 10-Q, the assets it transferred to PAGIC I LLC, but did include its
holdings of PAGIC I LLC Class A preferred stock on its balance sheet, in the
line item entry for securities available for sale. The PNC Form 10-Q for the
quarter ended June 30, 2001 stated:
During the first quarter of 2001, the Corporation announced the
decision to downsize the communications portfolio and certain portions
of the energy, metals and mining and large corporate portfolios. The
designated loans are included in Corporate Banking business results in
both periods presented. Management continues to evaluate opportunities
to reduce lending exposure and improve the risk/return characteristics
of this business.
...
Loans were $44.2 billion at June 30, 2001, a $6.4 billion decrease from
year-end 2000 primarily due to residential mortgage loan
securitizations and reductions in most commercial loan categories as a
result of continuing efforts to reduce balance sheet leverage.
The second quarter Form 10-Q also stated that PNC had $374 million in
nonperforming loans and $390 million in total nonperforming assets. These
figures did not include $84 million in nonperforming assets among the $257
million of loans that PNC had transferred to PAGIC I LLC.
PNC's second quarter Form 10-Q did not provide any disclosure
concerning the PAGIC I transaction.
5. PNC'S SEPTEMBER 18, 2001 REGISTRATION STATEMENT
On September 18, 2001, PNC filed with the Commission a registration
statement on Form S-3 (the "September 18, 2001 registration statement") that
would allow it to offer and sell approximately $4 billion of common stock,
preferred stock, warrants, guarantees, depositary shares and debt securities.
This filing was for a shelf registration of these securities, such that PNC
could offer and sell the registered securities from time to time pursuant to
applicable rules of the Commission. The September 18, 2001
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registration statement incorporated by reference, among other things, the Form
10-Q filed with the Commission by PNC for the second quarter of 2001.
6. PNC'S PRESS RELEASE AND FORM 10-Q FOR THE QUARTER ENDED
SEPTEMBER 30, 2001
In a press release issued on October 18, 2001 and in a Form 10-Q filed
with the Commission on November 14, 2001, PNC disclosed its financial
performance and financial condition for the third quarter of 2001. In both the
press release and the Form 10-Q, PNC did not include on its balance sheet the
assets it transferred to PAGIC I LLC and PAGIC II LLC, but did include its
holdings of PAGIC I LLC and PAGIC II LLC Class A preferred stock in its line
item entry for securities available for sale.
a. THE OCTOBER 18, 2001 PRESS RELEASE
In the October 18, 2001 press release, PNC announced that its earnings
per share for the third quarter of 2001 were $1.02. The press release noted,
"Loans declined $8.5 billion from December 31, 2000 to $42.1 billion at
September 30, 2001 as a result of ongoing efforts to reduce lending leverage."
The press release later noted, "Total assets were $71.9 billion at September 30,
2001 compared with $69.9 billion at September 30, 2000. Average interest-earning
assets were $57.9 billion for the third quarter of 2001 compared with $59.7
billion for the third quarter of 2000. The decrease was primarily due to a $2.5
billion decrease in commercial loans related to initiatives to downsize certain
higher-risk, non-strategic portfolios."
The October 18, 2001 press release further stated that PNC had $361
million in nonperforming loans and $374 million in total nonperforming assets.
These figures did not include a total of $207 million in nonperforming assets
among the assets that PNC had transferred to PAGIC I LLC and PAGIC II LLC.
This release made no mention of any of the PAGIC transactions into
which PNC had entered by October 18, 2001 (i.e., PAGICs I and II).
b. PNC'S OCTOBER 25, 2001 PROSPECTUS
Certain financial results set forth in the October 18, 2001 press
release were also set forth in a prospectus relating to an offering made
pursuant to the September 18, 2001 registration statement, which prospectus was
filed with the Commission on October 25, 2001 and utilized in the offer and sale
of approximately $1 billion of debt securities on or about October 29, 2001. In
particular, the prospectus announced that PNC's earnings per share for the third
quarter of 2001 were $1.02.
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C. THE THIRD QUARTER FORM 10-Q
The PNC Form 10-Q for the quarter ended September 30, 2001 reported
that PNC's earnings per share for that quarter were $1.02 per share. The Form
10-Q also stated:
Loans were $42.1 billion at September 30, 2001, a decrease of $8.5
billion from year-end 2000 primarily due to residential mortgage loan
securitizations and reductions in most commercial loan categories as a
result of continuing efforts to reduce balance sheet leverage.
...
At September 30, 2001, the securities available for sale balance
included a net unrealized gain of $79 million, which represented the
difference between fair value and amortized cost. The comparable amount
at December 31, 2000 was a net unrealized loss of $54 million. Net
unrealized gains and losses in the securities available for sale
portfolio are included in accumulated other comprehensive income or
loss, net of tax or, for the portion attributable to changes in a
hedged risk as part of a fair value hedge strategy, in net income.
The third quarter Form 10-Q stated that PNC had $361 million in
nonperforming loans and $374 million in total nonperforming assets. These
figures did not include a total of $207 million in nonperforming assets among
the $592 million of troubled assets that PNC had transferred to PAGIC I LLC and
PAGIC II LLC.
This Form 10-Q did not provide any disclosure concerning the PAGIC
transactions into which PNC had entered by the date the Form 10-Q was filed,
November 14, 2001 (i.e., PAGIC I and PAGIC II).
7. BANK HOLDING COMPANY SUPERVISORS RAISE CONCERNS ABOUT PAGIC
TRANSACTIONS
During the summer and fall of 2001, PNC had incomplete communications
about the PAGIC transactions with the Board, and the Federal Reserve Bank of
Cleveland (the "Reserve Bank"). On October 23, 2001, the staff of the Reserve
Bank sent PNC a letter raising various accounting issues and requesting
additional information about the PAGIC I transaction. PNC responded in writing
to this letter on December 12, 2001. The response addressed only the PAGIC I
transaction. Shortly before sending the response, PNC informed the Reserve Bank
that it previously had closed the PAGIC III transaction.
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8. PNC'S DECEMBER 6, 2001 REGISTRATION STATEMENT
On December 6, 2001, PNC filed with the Commission a registration
statement on Form S-8, in order to register the offer and sale of certain shares
of common stock. This registration statement incorporated by reference the Forms
10-Q filed by PNC with the Commission for the second and third quarters of 2001.
9. PNC'S JANUARY 17, 2002 PRESS RELEASE
On January 11, 2002, Board staff directed PNC to consolidate PAGIC I
LLC, PAGIC II LLC, and PAGIC III LLC on its bank holding company regulatory
reports for 2001. On January 15, 2002, a meeting was held with senior management
of PNC and staff of the Board to further explain in detail the basis of the
Board's directive to consolidate PAGIC I LLC, PAGIC II LLC, and PAGIC III LLC.
The Board advised PNC that nonconsolidation was not appropriate.
On January 17, 2002, PNC issued a press release announcing its fourth
quarter and full-year 2001 financial results. In this release, PNC stated that
its earnings per share for 2001 were $1.91, and that its fourth quarter loss
would be ($1.15) per share. PNC also stated that it had reduced its
institutional loan portfolio through, among other things, "sales of
institutional loans to subsidiaries of a third party financial institution." The
release went on to note that, "[v]enture capital assets were reduced to $424
million through a sale to a subsidiary of the same institution . . . ."
The January 17, 2002 press release also presented a table setting forth
PNC's nonperforming assets by type, which included a total of $268 million in
nonperforming assets as of December 31, 2001. The release went on to state that
"[e]xcluded from the above table and reflected below are . . . certain assets
sold to subsidiaries of a third party financial institution. These assets will
be included in nonperforming assets in PNC's bank holding company regulatory
filings." The filings to which this release referred were filings to be made by
PNC with the Board as required by the federal banking laws. The release
continued by disclosing that the amounts of nonperforming assets sold to the
subsidiaries of the third party financial institution were $84 million as of
June 30, 2001, $207 million as of September 30, 2001 and $172 million as of
December 31, 2001. This was the first time that PNC publicly disclosed the
amounts of the nonperforming assets among the assets it had transferred to the
PAGIC entities, although it did not incorporate them into the table for
nonperforming assets.
The January 17, 2002 press release did not consolidate the assets of
the three PAGIC special purpose entities into PNC's financial statements. It
also did not set forth any explanation why consolidation might be appropriate
for PNC's bank regulatory filings but not for filings made with the Commission.
Furthermore, it did not disclose the impact consolidation might have on PNC's
announced 2001 earnings of $1.91 per share.
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10. PNC ANNOUNCES A RESTATEMENT WITH RESPECT TO PAGIC ENTITIES
On the morning of January 29, 2002, PNC announced that it would revise
its fourth quarter financial results and restate its second and third quarter
2001 financial statements to reflect the consolidation of PAGIC I LLC, PAGIC II
LLC, and PAGIC III LLC. It also disclosed that consolidation would result in a
reduction of 2001 income by $155 million, equivalent to a drop of earnings per
share of 38%, from $1.91 per share to $1.38 per share.(3) After PNC made this
announcement, the market price of PNC common stock fell from a closing price of
$61.87 on January 28, 2002 to $56.08 on January 29, 2002 (equivalent to a 9.4%
drop), with a further drop the next day, January 30, 2002, to a closing price of
$55.71 (equivalent to a two-day drop of 10%).
11. PNC FILES ITS RESTATED FINANCIAL RESULTS
On March 29, 2002, PNC filed amended Forms 10-Q for the quarters ended
June 30, 2001 and September 30, 2001 that included restated financial results.
The amended Form 10-Q for the quarter ended September 30, 2001 set forth PNC's
restated financial results for the third quarter of 2001, including, among other
things, PNC's earnings per share for this quarter, which were $0.84 per share
(approximately 18% less than the $1.02 per share reported in PNC's original Form
10-Q for this quarter).
Also on March 29, 2002, PNC filed its Form 10-K for the full year 2001.
This filing revealed that PNC's earnings per share for the year were $1.26,
(which meant that the $1.91 per share figure originally announced by PNC on
January 17, 2002 was overstated by 52%, and that the $1.38 per share figure
announced by PNC on January 29, 2002 was 10% overstated). This filing also
revealed that the actual fourth quarter loss for PNC was ($1.52) per share, or
25% greater than the ($1.14) per share loss for the fourth quarter originally
disclosed in PNC's January 3, 2002 press release and 24% greater than the
($1.15) per share fourth quarter loss announced in PNC's January 17, 2002 press
release. Furthermore, the Form 10-K disclosed that PNC had charged $240 million
against pre-tax income as a result of valuation write-downs relating to
consolidation of the PAGIC entities.
D. DISCUSSION
Section 10(b) of the Exchange Act and Rule 10b-5 thereunder prohibit,
among other things, the making of material misrepresentations or omissions, with
scienter, in connection with the purchase or sale of any security. Section 10(b)
of the Exchange Act and Rule 10b-5 thereunder also make it unlawful to make any
untrue statement of a material fact or to omit to state a material fact
necessary in order to make the statements
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(3) PNC subsequently disclosed in its Form 10-K for 2001 that its earnings per
share for the full year 2001 were $1.26.
13
made, in the light of the circumstances under which they were made, not
misleading. A statement is deemed material if there is a "substantial likelihood
that a reasonable investor would consider it important" in deciding whether to
purchase or sell securities or that a reasonable investor would have viewed
disclosure of the omitted fact as altering the "total mix" of information
available. Basic Inc. v. Levinson, 485 U.S. 224, 231-32 (1988). Sections
17(a)(2) and 17(a)(3) of the Securities Act make it unlawful, in the offer or
sale of securities, by the use of any means or instruments of transportation or
communication in interstate commerce, or the mails, to obtain money or property
by means of an untrue statement of a material fact or any omission to state a
material fact necessary in order to make the statements made, in the light of
the circumstances under which they were made, not misleading, or to engage in
any transaction, practice, or course of business which operates or would operate
as a fraud or deceit upon the purchaser.
Section 13(a) of the Exchange Act requires issuers of registered
securities to file periodic reports with the Commission containing information
prescribed by specific Commission rules. Rule 13a-1 requires the filing of
annual reports on Form 10-K. Rule 13a-13 requires the quarterly filing of a Form
10-Q. Rule 12b-20 requires, in addition to information required by Commission
rules to be included in periodic reports, such further material information as
may be necessary to make the required statements not misleading. These reports
are required to be complete and accurate. See SEC v. Savoy Industries, 587 F.2d
1149, 1165 (D.C. Cir. 1978). Under both the federal banking laws(4) and the
federal securities laws,(5) PNC is, and was at all relevant times, required to
comply with GAAP in its filings with the Board and with the Commission.
Section 13(b)(2)(A) of the Exchange Act requires issuers to "make and
keep books, records, and accounts, which in reasonable detail, accurately and
fairly reflect the transactions and dispositions of the assets of the issuer."
"A company's `books and records' include not only general ledgers and accounting
entries, but also memoranda and internal corporate reports." In the Matter of
Gibson Greetings, Inc., Ward A. Cavanaugh, and James H. Johnsen, Admin. Proc.
File No. 3-8866, Release No. 34-36357, 60 SEC Docket 1401 (Oct. 11, 1995).
PNC's accounting for the PAGIC transactions did not conform to GAAP.
PNC's failure to account properly for the PAGIC transactions resulted in a
material overstatement of its earnings for the third quarter of 2001, among
other things. The false and misleading disclosures it made in its Forms 10-Q for
the second and third quarters of 2001 created a materially inaccurate picture of
the extent to which it was reducing its exposure to commercial lending
activities, and the risks attendant thereto. As is discussed below, GAAP
required PNC to consolidate the assets of the PAGIC
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(4) See, instructions to Form Y-9C.
(5) 17 C.F.R.ss.210.4-01(a)(1).
14
entities. This meant PNC remained exposed to the risks presented by the assets
transferred to the PAGIC entities, and to the possibility of charges against its
earnings for losses arising from those assets. Furthermore, PNC offered and sold
securities in the fall of 2001 by means of registration statements that
incorporated by reference one or both of its Forms 10-Q for the second and third
quarters of 2001 and a prospectus that materially overstated its third quarter
earnings and otherwise inaccurately portrayed its financial performance.
In addition, PNC recklessly made materially false and misleading
disclosures in its January 17, 2002 press release about its financial condition,
including, among other things, a material overstatement of its 2001 earnings.
PNC also failed to maintain accurate books and records because it did
not consolidate on its balance sheet the assets held by the PAGIC entities or
record the impact of losses on those assets on PNC's 2001 earnings.
1. PNC'S ACCOUNTING FOR THE PAGIC TRANSACTIONS DID NOT CONFORM WITH
GAAP
Topic D-14, Transactions Involving Special Purpose Entities, addresses
whether, under GAAP, transfers of assets to special purpose entities should be
treated as sales and whether or not it is appropriate for sponsoring companies
to consolidate the financial statements of special purpose entities. For
nonconsolidation and sales recognition by the sponsor or transferor to be
appropriate, the majority owner of the special purpose entity must be an
independent third party who has made a substantive capital investment in the
special purpose entity, has control of the special purpose entity, and has
substantive risks and rewards of ownership of the assets of the special purpose
entity. Conversely, nonconsolidation and sales recognition are not appropriate
by the sponsor or transferor when the majority owner of the special purpose
entity makes only a nominal capital investment, the activities of the special
purpose entity are virtually all on the sponsor's or transferor's behalf, and
the substantive risks and rewards of the assets or the debt of the special
purpose entity rest directly or indirectly with the sponsor or transferor.(6) At
the time of the PAGIC transactions, three percent was the minimally acceptable
amount under GAAP to indicate a substantive capital investment sufficient for
nonconsolidation, though a greater investment may be necessary depending on the
facts and circumstances.(7) The PAGIC transactions did not satisfy these
criteria.
The provisions of the agreements for each PAGIC transaction provided
that the insurance company's investment was substantially protected from loss by
the
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(6) Emerging Issues Task Force, Topic D-14, Transactions Involving Special
Purpose Entities.
(7) Emerging Issues Task Force, Issue No. 90-15, Impact of Nonsubstantive
Lessors, Residual Value Guarantees, and Other Provisions in Leasing
Transactions, Response to Question No. 3.
15
investment grade assets purchased with the proceeds of that investment (to which
the insurance company had priority in the event of a liquidation of a PAGIC
entity).(8) The insurance company, on the other hand, did not effectively enjoy
any gains from the loans and other assets transferred by PNC to the PAGIC
entities, because PNC had effective control over the liquidation of the PAGIC
entities. As noted above, PNC could decide at any time to liquidate the PAGIC
entities by converting its Class A preferred stock to Class A common stock and
voting to liquidate, whereupon it would be able to capture the benefit of any
improvement in the value of the assets that it had transferred to the
liquidating entity. The insurance company, however, did not have the ability to
benefit from an improvement in the value of these assets. PNC also bore
substantial risk on the loans because the dividends on its preferred stock were
noncumulative and payable only if those loans performed or were sold and after
payment of, among other things, the management fee to the insurance company, and
even then only with the approval of the insurance company. As a result of the
foregoing, PNC, and not the insurance company, had substantive risks and rewards
of ownership.
The PAGIC transactions also did not satisfy the requirement that the
majority owner (in this case, the insurance company) make a substantive
investment. As required by the documentation for each PAGIC transaction, the
first year's management fee owed to the insurance company was paid on the date
that PNC and the insurance company entered into the transactions. These advance
payments of the first year's management fees had the substantive effect of
making the investment actually made by the insurance company effectively less
than the three percent benchmark.(9) Thus, the insurance company did not make a
sufficiently large investment in the PAGIC entities to be substantive under
GAAP.
Because the PAGIC transactions did not satisfy the criteria for
nonconsolidation of special purpose entities, PNC should have consolidated the
PAGIC entities in its financial statements. PNC's accounting for the PAGIC
entities as reported in its filings with the Board and with the Commission for
the second and third quarters of 2001 thus did not conform to GAAP. PNC
improperly excluded the PAGIC entities' assets from its balance sheet for the
quarters ended June 30 and September 30, 2001, materially overstated the amounts
of securities available for sale by improperly including the
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(8) Furthermore, the PAGIC transaction agreements provided that the insurance
company would have preferences to and reserves taken from the income of the
PAGIC entities to secure payment of its management fees, the result of
which was to allow the insurance company to effectively more than recoup
its investment in the PAGIC entities in four years. The fact that the
insurance company received an annual management fee of 0.75% of assets for
doing very little, while PNC conducted the principal activities of the
PAGIC entities by servicing the loans and other assets they held for an
annual servicing fee of 0.5%, suggests that the annual management fee was a
means of effectively returning capital to the insurance company prior to
any liquidation of the PAGIC entities.
(9) Emerging Issues Task Force Issue No. 96-21, Response to Question No. 6,
states in relevant part, "To the extent that the fees reduce the equity
capital investment below the minimum amount required, the owners of record
would not be considered to have a substantive residual equity capital
investment that is at risk...."
16
PAGIC preferred stock in this line item and materially overstated its earnings
for the third quarter of 2001. In addition, the amounts of nonperforming assets
were also materially understated in these filings.
2. PNC'S FALSE AND MISLEADING PORTRAYAL OF ITS REDUCTION OF LOAN
PORTFOLIO EXPOSURE AND OF THE IMPACT OF THE PAGIC
TRANSACTIONS ON ITS FINANCIAL CONDITION FOR THE SECOND AND
THIRD QUARTERS OF 2001
In the above-described press releases and Forms 10-Q for the second and
third quarters of 2001, PNC depicted itself as implementing a corporate strategy
of reducing its exposure to commercial lending and the risks attendant thereto.
PNC entered into the PAGIC transactions as part of this strategy. However, as
noted above, PNC's accounting for the PAGIC transactions did not conform to GAAP
for several reasons including the fact that payment of the first year's
management fee to the insurance company was made in advance, on the date of the
closing of the transaction. This advance payment had the substantive effect of
immediately reducing the insurance company's investment in the PAGIC entities
below the three percent threshold. Because of the structure of the PAGIC
transactions PNC continued to bear the risk of loss as to troubled or
non-performing loans and venture capital assets transferred by PNC to the PAGIC
entities. Those losses, if and when incurred, should have been charged against
current earnings. In addition, various other line items and other figures noted
above, including the amounts of nonperforming loans, nonperforming assets,
securities available for sale, and reductions in loans held for sale, were all
materially inaccurate, in that they were improperly recorded on the assumption
that the assets transferred to PAGIC I LLC and PAGIC II LLC had been removed
from PNC's financial statements. In fact, PNC's nonperforming assets and loans
were materially greater than disclosed, because they should have included
certain assets transferred to PAGIC I LLC and PAGIC II LLC, and its reductions
in loans were materially overstated. Moreover, PNC materially overstated
earnings per share for the third quarter of 2001 because it did not include
write-downs that it should have taken with respect to assets transferred to
PAGIC I LLC. Thus, the press releases and Forms 10-Q materially overstated the
extent to which PNC was reducing its exposure to its loan portfolio in the
second and third quarters of 2001, and the press release and Form 10-Q in the
third quarter of 2001 materially overstated PNC's income for that quarter.
PNC's recordation of its interests in the PAGIC entities as "securities
available for sale" was also materially misleading. Unrealized gains and losses
on the assets properly recorded in this category do not have an impact on
current earnings, except for a circumstance inapplicable in this instance.
However, PNC's actual interests in the PAGIC entities were, for financial
reporting purposes, the underlying assets and not the preferred stock that the
PAGIC entities issued to PNC. Thus, by recording its interests in the PAGIC
entities as "securities available for sale," PNC inaccurately represented that
unrealized losses and gains on its interest in the PAGIC entities would not
affect current earnings.
17
PNC's Form 10-Q for the second quarter of 2001 was incorporated by
reference into its Forms S-3 and S-8 filed in September and December of 2001,
respectively. Its Form 10-Q for the third quarter of 2001 was incorporated by
reference into its Form S-8 filed in December 2001. Furthermore, certain
materially inaccurate financial results for the third quarter, including an
inaccurate figure for earnings per share, were included in its prospectus filed
on October 25, 2001. PNC should have known that its improper accounting and
disclosures would make these filings, used in the offer or sale of securities,
materially inaccurate.
3. OBLIGATIONS TO MAKE FULL DISCLOSURE
Issuers engaged in transactions with special purpose entities, or in
other transactions, particularly where the attainment of a particular financial
reporting result is a primary purpose, must be mindful that, even if the
transactions comply with GAAP, the issuer is required to evaluate the material
accuracy and completeness of the presentation made by its financial
statements,(10) as well as its disclosure obligations under the Commission's
rules and regulations, including, among other things, the rules and regulations
concerning Management's Discussion and Analysis of Financial Condition and
Results of Operations(11) and Quantitative and Qualitative Disclosures About
Market Risk.(12)
In addition, issuers must consider the economic and business realities
and risks of their corporate structures and affiliations, their financial
structures and financing methods, their lines of business and operational
activities, and ensure that the way they publicly portray themselves discloses,
as required, the material elements of those economic and business realities and
risks.
The structure of the PAGIC entities raises significant disclosure
issues. PNC transferred troubled or non-performing loans and venture capital
assets to the PAGIC entities, which then purchased zero-coupon Treasury
securities that eventually, after 30 years, would mature in the face amount of
the preferred stock issued to PNC. Although this structure purportedly would
prevent PNC from having to write down the value of the preferred stock because
it would ultimately not suffer any loss of its face value, the structure
camouflaged significant economic risk. While the insurance company's interest
was substantially protected from loss by virtue of its priority to the income
and principal of the investment grade securities purchased with the proceeds of
the insurance company's investment, PNC's preferred stock had no such
protection. In the event that a PAGIC entity were to be liquidated before the
preferred stock matured after 30 years, the actual amount that PNC would recover
on the preferred stock might
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(10) See, e.g.,In the Matter of Caterpillar Inc., 51 S.E.C. Docket 147 (Admin.
Proc. File No. 3-7692, March 31, 1992). See also Exchange Act Rule 12b-20.
(11) 17 C.F.R.ss.229.303.
(12) 17 C.F.R.ss.229.305.
18
be substantially less than the carrying value of the preferred stock. The
recoverable value of the zero-coupon Treasury security would, for much of the 30
years preceding its maturity, be substantially less than its face amount. Thus,
the actual recoverable value of the loans and other assets transferred to the
PAGIC entities in a liquidation process might be well below their value on the
dates they were transferred to the PAGIC entities.(13) Required portrayal would
entail going beyond merely disclosing the possibility of loss, and would include
describing in all material aspects what losses might occur and the circumstances
under which they could occur. In this regard, PNC should have, for the second
and third quarters of 2001, disclosed its use of the PAGIC entities, described
the structure of these transactions, disclosed the risks that these transactions
presented, and described what losses might occur and the circumstances under
which those losses could occur. These disclosures should have been made
regardless of whether or not PNC believed that the PAGIC transactions had
complied with GAAP.
Another example of disclosure that would be necessary to illuminate the
risks of the PAGIC transactions arises from the dividend feature of the
preferred stock held by PNC. The dividends on its preferred stock were
noncumulative and payable only if those loans performed or were sold and after
payment of, among other things, the management fee to the insurance company, and
even then, only if the insurance company approved the payment of dividends to
PNC. Since some of the loans and other assets were troubled, payment of
dividends to PNC was by no means assured. Thus, PNC continued to bear
substantial risks with respect to the troubled loans and other troubled assets
transferred to the PAGIC entities. While a purpose of PNC's entering into the
PAGIC transactions was to reduce volatility in its earnings caused by changes in
the quality of its loan portfolio, the potentially irregular nature of the
dividends payable on the preferred stock would have a counteractive effect on
this effort to reduce volatility in earnings, whether or not the PAGIC
transactions complied with GAAP. In light of PNC's statements in its press
releases and Forms 10-Q that it was reducing balance sheet leverage and lending
exposure, this information about the volatility of dividends was material and
PNC's omission of this information from the documents rendered the documents
materially misleading.(14)
In light of the matters discussed in sections IV.D. 1, 2 and 3 above,
PNC violated Sections 17(a)(2) and 17(a)(3) of the Securities Act, Sections
13(a) and 13(b)(2)(A) of the Exchange Act, and Exchange Act Rules 12b-20, 13a-1
and 13a-13.
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(13) The potential for such loss is illustrated by the $240 million charge
against income that PNC took for the full year 2001's income when it
consolidated the PAGIC entities onto its financial statements. As a matter
of economic reality, the zero-coupon Treasury securities did not insulate
PNC from loss.
(14) Even though the PAGIC entities each held a 30-year zero-coupon Treasury
security in an amount sufficient at maturity to redeem the preferred stock
at face value, the zero-coupon, which by definition did not pay dividends,
would not insulate PNC from volatility in dividend payments on the
preferred stock.
19
4. PNC'S MATERIALLY FALSE AND MISLEADING JANUARY 17, 2002 PRESS
RELEASE
PNC's January 17, 2002 press release concerning its fourth quarter and
full year 2001 financial performance was materially false and misleading. By
January 17, 2002, PNC was already aware that it would be required to restate its
2001 bank holding company regulatory reports to the Board to show consolidation
of the PAGIC entities. Nevertheless, notwithstanding that the federal banking
laws and the federal securities laws both require compliance with GAAP, PNC
recklessly presented its financial condition in the January 17, 2002 press
release without consolidating the PAGIC entities, in contravention of GAAP. In
the course of doing so, PNC, among other things, overstated its 2001 earnings by
52% (i.e., PNC's actual earnings per share were $1.26, but were disclosed in the
January 17, 2002 press release as $1.91). It also continued to understate its
fourth quarter loss, by 24% in this press release. The release announced the
loss as ($1.15) per share, when, as disclosed in PNC's Form 10-K for 2001, it
was actually ($1.52) per share. When PNC announced on January 29, 2002 that it
was restating its financial statements and disclosed that its 2001 earnings per
share would be $1.38,(15) its stock price fell approximately 10%. The January
17, 2002 press release was materially false and misleading because it failed to
disclose that the financial information it set forth did not comply with GAAP,
nor did it explain how and to what extent this financial information differed
from GAAP.
In the January 17, 2002 press release, PNC also stated that it had
reduced its institutional loan portfolio through, among other things, "sales of
institutional loans to subsidiaries of a third party financial institution." The
release went on to note that, "[v]enture capital assets were reduced to $424
million through a sale to a subsidiary of the same institution . . . ." These
statements were references to PNC's transfers of troubled assets to the PAGIC
entities, and were materially false and misleading, in that these statements
implied that those transfers were effective for financial reporting purposes and
allowed PNC to remove these assets from its financial statements. In fact, PNC
had not effectively removed these assets from its financial statements and
continued to bear the risks associated with these assets, including material
charges against 2001 earnings that were improperly omitted from the January 17,
2002 press release.
As previously noted, the January 17, 2002 press release included a
table depicting "Nonperforming Assets Data," which presented amounts of
nonperforming assets by type that did not include nonperforming assets held by
the PAGIC entities. Immediately below this table was a note stating that
"[e]xcluded from the above table and reflected below are equity management
assets that are carried at fair value and certain assets sold to subsidiaries of
a third party financial institution. These assets will be included in
nonperforming assets in PNC's bank holding company regulatory
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(15) As noted above, PNC's 2001 earnings were per share were ultimately
reported as $1.26 in its Form 10-K filed on March 29, 2002.
20
filings." The release next presented data that included the amounts of
nonperforming assets held by the PAGIC entities. This separate presentation of
some of the PAGIC assets did not rectify PNC's false and misleading statements
elsewhere in the press release because: (a) it did not disclose that PNC's
presentation of nonperforming assets in this manner did not conform to GAAP, (b)
it did not disclose that compliance with GAAP would involve consolidation of
these assets, and other assets, on PNC's financial statements, and (c) it did
not disclose that consolidation as required by GAAP would result in a charge to
earnings that would render the disclosed earnings per share to be 52%
overstated. It was also materially incomplete and misleading, in that it omitted
to disclose that several hundreds of millions of dollars worth of other troubled
assets would have to be incorporated back onto PNC's balance sheet, together
with significant write-downs that, as disclosed in PNC's Form 10-K for 2001,
totaled $240 million.
In light of the matters discussed in section IV.D. 4 above,
PNC violated Section 10(b) of the Exchange Act and Rule 10b-5 promulgated
thereunder.
V.
In view of the foregoing, it is appropriate to impose the sanction
specified in PNC's Offer of Settlement.
VI.
ORDER
ACCORDINGLY, THE COMMISSION HEREBY ORDERS THAT, pursuant to Section 8A
of the Securities Act and Section 21C of the Exchange Act, PNC cease and desist
from committing or causing any violations of, and committing or causing any
future violations of, Sections 17(a)(2) and 17(a)(3) of the Securities Act,
Sections 10(b), 13(a) and 13(b)(2)(A) of the Exchange Act, and Exchange Act
Rules 10b-5, 12b-20, 13a-1 and 13a-13.
By the Commission.
Jonathan G. Katz
Secretary
21