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.

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.

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.

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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.”


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