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Orrstown Bank lawsuit turns on questions about disclosureBut lawsuit may have merit, expert says

- Last modified: June 8, 2012 at 10:37 AM

Fundamentally, the lawsuit filed against Orrstown Bank last month is about disclosure, according to local investors and legal experts.

Public companies have a legal obligation to provide reliable and complete information to their investors. Good disclosure is especially vital in the case of banks, said Peter Labella, president of FMA Advisory Inc., a wealth management firm based in Harrisburg.

Though most bank loans are backed by collateral, a loan is still in some sense a liability, its status as an asset based on the promise to repay. Moreover, loan relationships are confidential.

Those factors force bank investors to rely a great deal on managers' candor and competence, Labella said.

"Banks are very, very difficult to analyze," he said. "Until (a loan) goes nonperforming, it's almost impossible to see."

Haverford-based law firm Chimicles & Tikellis filed the class-action suit May 25 in federal court for Pennsylvania's Middle District. The complaint alleges Orrstown made "false and misleading statements" in a prospectus for a $37.5 million stock offering in March 2010, and in multiple public presentations thereafter.

The suit claims the Shippensburg-based bank kept its stock price artificially high by repeatedly vouching for the quality of its loan portfolio and risk management practices, though in reality Orrstown had serious problems in those areas. When they were revealed, the suit says, the bank's stock price plunged overnight, causing significant loss to the investors who had believed the company's earlier avowals.

The suit names SEPTA, the Southeastern Pennsylvania Transportation Authority, as lead plaintiff and Orrstown Bank, its holding company and the members of both boards as defendants.

It seeks damages for anyone who bought stock in the March 2010 offering or in the subsequent 19 months. The relevant period ends Oct. 27, 2011, the day after Orrstown announced it was suspending its dividend at the direction of the Federal Reserve, its federal regulator.

Orrstown categorically denied the charges in a statement filed May 31 with the U.S. Securities and Exchange Commission.

"The company believes that the allegations in the complaint are without merit and intends to vigorously defend against these claims," the bank said.

Bank officials cannot comment further, Orrstown spokesman Mark Bayer said.

Analyst Matt Schultheis of the West Conshohocken investment firm Boenning & Scattergood said the lawsuit was not a surprise; nor was the May 14 resignation of Bradley Everly, Orrstown's treasurer and chief financial officer.

"In these circumstances, somebody has to go," Schultheis said.

The suit hasn't changed his view of the bank, he said, but his view isn't exactly bullish. He rated the stock "neutral" in an April 30 research note and revised his estimate of Orrstown's 2012 results from a profit of 68 cents per share to a loss of 92 cents per share.

Orrstown, a $1.45 billion bank with 21 branches, lost $32 million in 2011. Its stock has dropped nearly 75 percent from its peak that year.

For the first quarter of 2012, the bank reported a loss of $8.2 million. Its nonaccruing assets stood at $82.1 million as of March 31, down slightly from $83.7 million at the end of 2011, according to its quarterly report.

In public statements, the bank has blamed its difficulties on "the lingering effects of the sluggish economy, and in particular, a depressed local real estate market."

In early 2010, however, Orrstown was touting its ability "to steer clear of many obstacles that other financial institutions encountered."

In documents associated with the March 2010 stock offering, in press releases and at investor presentations, Orrstown CEO Thomas Quinn and other executives assured investors of Orrstown's "conservative lending practices," "high-quality loan portfolio" and "minimization of risk."

Orrstown's financial results and regulators' enforcement actions show those assertions to be untrue, the suit alleges.

The suit asserts Orrstown violated two disclosure laws, the Securities Acts of 1933 and 1934. The former governs the stock offerings; the latter applies to purchases of stock on the open market.

A simple "material misstatement or omission" constitutes a violation of the 1933 law, Cole said, but to violate the 1934 law, the statement or omission must be made with fraudulent intent. For that reason, violations made in a stock offering are easier to prove, he said.

Many banks tout their underwriting standards, of course, and no bank can avoid losses entirely, especially when the economy at large does poorly. Banks everywhere struggled during the recession with commercial loans that had seemed perfectly safe before 2008. Courts haven't been impressed with general claims made in hindsight about banks failing to monitor risk, Cole said.

However, if bank managers know a particular loan has gone irreversibly bad, but continue to carry it as performing, "that would strongly support the plaintiffs' case," he said.

The complaint makes such an allegation: "The company changed its criteria for classifying the performance of a loan so that the company could delay reporting loans that were clearly non-performing until well after the March 2010 offering," it says.

As evidence, the complaint cites quarterly reports showing Orrstown's listed nonaccrual loans grew from $4.27 million just before the stock offering to $23 million afterward.

It also focuses on Orrstown's lending relationship with Yorktown Funding Inc., a Camp Hill-area construction loan company. Yorktown Funding declared bankruptcy in February 2010; on March 19, Orrstown filed an SEC document saying it might not be able to recover $8.6 million it had lent the ailing lender.

Orrstown subsequently spent months working with Yorktown funding on a recapitalization plan. At one point the bank was pledged to lend an additional $7.8 million, but that deal broke down. In July 2011, Orrstown wrote off the $8.6 million in toto.

Yorktown was heavily involved in mortgage lending in south Florida, an epicenter of the housing bubble. Other banks had quickly stopped lending to such companies, the suit says. Orrstown's ongoing efforts to salvage the Yorktown relationship "highlighted to investors fundamental flaws and lapses in (the bank's) underwriting and management-led loan review process," the suit says.

Orrstown is committed to returning to profitability, and regulators' demands will help make it "a better bank," CEO Quinn told The (Harrisburg) Patriot-News in a May 26 article.

The bad loans were limited to a "very confined number," and the bank is healthy overall, he said.

Schultheis called Orrstown's recovery "a work in progress." He doubts the bank will be sold, he said.

"I don't think they could get a price that they would be willing to take at this stage of the game," he said.

Chimicles & Tikellis said it is seeking additional lead plaintiffs for the suit and looks forward to finding additional evidence through the discovery process as the suit moves forward.

Orrstown Bank — a timeline

April 29, 2009 — Orrstown debuts on the Nasdaq stock index under the ticker symbol ORRF.

February 2010 — Camp Hill-area mortgage lender Yorktown Funding Inc. files for Chapter 11 bankruptcy.

March 10, 2010 — Orrstown stock closes at $36.42, its high for the year.

March 15, 2010 — Orrstown files its 2009 annual report, vouching for "a high quality loan portfolio with no unusual or undue concentrations of credit."

March 19, 2010 — Orrstown says in a SEC filing that it plans to list $8.6 million in loans to Yorktown as nonperforming in its next quarterly report.

March 24, 2010 — Orrstown stock drops 23 percent in two days.

March 29, 2010 — Orrstown announces completion of a $37.5 million stock offering.

May 2010 — Orrstown reclassifies $18.75 million in loans as nonperforming.

November 2010 — Orrstown ceases to say in quarterly statements it is "not aware of any current recommendations" by regulators that could impact its operations.

March 31, 2011 — The Federal Reserve and the Pennsylvania Department of Banking launch a non-public examination of Orrstown.

April 6, 2011 — Orrstown stock closes at a high for the year of $29.28 per share.

July 14, 2011 — Orrstown determines its Yorktown Funding loans are a total loss and charges off the $8.6 million in principal. Its stock price drops 23 percent in two business days.

July 28, 2011 — Orrstown announces a second-quarter loss of $10.6 million and says it is outsourcing "certain credit review responsibilities."

October 2011 — Orrstown announces it is suspending its quarterly dividend at the direction of the Federal Reserve. CEO Thomas Quinn calls the bank "safe and sound" in a letter to investors. Its stock price drops more than 30 percent in two days.

March 2012 — The Federal Reserve and Pennsylvania Department of Banking issue enforcement actions requiring Orrstown to improve its risk management and loan portfolio.

May 25, 2012 — Class action lawsuit filed. Orrstown stock closes at $7.84 per share.

Source: SEC documents, complaint filed May 25 in federal court by Chimicles & Tikellis, Yahoo Finance

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