The D & O Diary : Directors and Officers Liability and Insurance : The D & O Diary : Kevin LaCroix : Securities Laws, Corporate Fraud, D & O Litigation

In a prior post (here), I described the growing litigation risk arising out of credit default swap (CDS) transactions. In their recent overview of subprime-related litigation entitled “The Pebble and the Pool: The (Global) Expansion of Subprime Litigation” (here), John Doherty and Richard Hans of the Thacher Proffitt and Wood law firm note that “more lawsuits involving credit default swaps are likely to be initiated in the near future, as the current trend has the potential for huge losses resulting from the defaults on ‘high-yield’ or ‘junk” bonds in connection with the general market failure.”

In a June 1, 2008 article entitled “First Came the Swap. Then It’s the Knives” (here), New York Times columnist Gretchen Morgenson takes a close look at one failed CDS transaction and the litigation that has followed, about which she quotes “experts” as saying that the case is “the first of what will likely be a flood of disputes between big banks and hedge funds that typically strike swap deals.”

The swap involved was issued by a Paramax Capital hedge fund in early 2007 to insure $1.31 bilion of AAA-rated super senior notes that “reflected performance of subprime mortgages in a collateralized debt obligation underwritten by UBS.” The Paramax fund, which itself had just $200 million in capital, organized a special purpose entity capitalized with just $4.6 million, to conduct the swap. Paramax was to receive an annual fee of 0.155 percent of the notes’ $1.31 billion value (or slightly more than $2 million), and would be subject to additional collateral requirements if the notes’ value declined.

Over the course of 2007, UBS presented escalating requirements that Paramax post a total of $33 million in additional collateral. When Paramax refused, UBS sued. According to the Times article, Paramax now contends that a UBS managing director (no longer with the company) induced Paramax to enter the transaction, and to address Paramax’s concern that it might be called upon to post additional collateral, reassured Paramax that the mark-to-market risk on the underlying securities was low because UBS used “subjective valuations” designed to reduce the impact of market fluctuations.

As detailed further in the Times article, there are a number of interesting things about this transaction. From my perspective, the most noteworthy aspect is that UBS considered a special purpose entity with only $4.6 million in capital to be an appropriate source of default insurance for instruments with a face value of $1.31 billion. UBS’s contractual right to demand additional collateral from the hedge fund, which itself had capital of only $200 million (which presumably was deployed in other ways and accordingly unavailable in its entirety as additional collateral), seems a woefully inadequate explanation for this transaction.

The Naked Capitalism blog (here) notes that “UBS was clearly well aware of Paramax’s limits, so the next question is: was UBS solely responsible for pulling a fast one on the CDO buyers or is Paramax a co-conspirator?”

This litigation between UBS and Paramax resembles the CDO Plus litigation I discussed in my prior post (here) about swaps. In those cases as well, a thinly capitalized hedge fund was unable to meet demands for additional collateral and wound up in litigation with the large commercial banks that had purchased CDS protection from the fund. As consequences from the credit crisis continue to roll through the financial marketplace, CDS counterparties are likely to face further collateral demands, which can only fuel further litigation.

But the counterparties themselves are not the only potential litigants. Behind the CDS purchaser are the investors who made investments in the belief that the investment interests were “insured” against default. As it emerges that this insurance depended upon facially inadequate counterparties, investors may join the fray. As the Naked Capitalism blog post linked above notes, “since over 30% of the credit default swaps were written by hedge funds, many of whom were probably as incapable as Paramax of performing in the event of default, it’s not unreasonable to assume that some of these CDS lawsuits will lay the groundwork for investor litigation.”

Another aspect of the role of CDS in the financial marketplace is leading to yet another variety of CDS-related litigation. That is, because there is no requirement that a CDS buyer hold the underlying instruments, swaps are often used as a means to speculate on interest spreads. That means that these instruments can serve an investment purpose separate apart from their insurance purpose.

The problem for companies that have used swaps for investment purposes is that as a result of the credit turmoil, the market for these instruments in an uproar, and the instruments’ valuation has become uncertain. Indeed, as recent circumstances have shown, these valuation issues are present whether a company holds the swap as an investor or as an insurer. Several of the most significant recent financial institution asset write-downs have involved these CDS valuation uncertainties; for example, a substantial part of the recent write-downs of Swiss Re and of American International Group related to CDS valuation issues. Significantly, in both instances, shareholders litigation ensued following the write-downs. (Refer here regarding the Swiss Re litigation and refer here regarding the AIG litigation). It seems highly improbable that there will not be further shareholder litigation over these CDS valuation issues.

As reflected in the June 6, 2008 Wall Street Journal (here), the recent signs are that the turmoil in the financial marketplace is far from over , as a result of which the pressure on CDS will remain, and there likely will be further litigation. Even if only a tiny percentage of CDS transactions beget litigation, the problem could be huge. According to the International Swaps and Derivatives Association (here), the aggregate notional value of credit defaults swaps outstanding at the end of 2007 was $62 trillion, an amount which arguably exceeds the value of bank deposits worldwide. It is nearly three times the value of the U.S. stock markets.

With numbers that astronomical, even a small sliver represents a mammoth problem. With nominal values of $62 trillion, issues concerning valuation present a potentially frightening prospect for companies, their investors, and their insurers. As Time Magazine said in its recent article entitled “Credit Default Swaps: The Next Crisis?” (here), “a meltdown in the CDS market has potentially even wider ramifications nationwide than the subprime crisis.”

Susan Mangiero has an interesting post (here) on her Pension Risk Matters blog about these issues.

The “Pebble in the Pool” article I linked to above presents a very good overview of the subprime-related litigation generally and is worth reviewing on its own for those purposes.

Another Subprime-Related Lawsuit Against Mutual Fund: On June 5, 2008, plaintiffs’ attorneys initiated a securities class action lawsuit in the United States District Court for the District of Massachusetts under the Securities Act of 1933 on behalf of purchasers of the Fidelity Ultra-Short Bond Fund who purchased their fund shares within three years of the lawsuit’s filing.

According to the complaint (which can be found here), the defendants in the lawsuit include Fidelity Management & Research Company, which is the investment advisor to the Fidelity mutual funds, and related entities, and also include the 21 individual trustees of the Ultra-Short Bond Fund.

According to the plaintiffs’ lawyers’ June 5, 2008 press release describing the complaint (which can be found here), the plaintiffs allege that the defendants solicited investors to purchase fund shares by making statements that described the fund as a fund that “(i) “Seeks a high level of current income consistent with the preservation of capital”; (ii) “allocates its assets across different market sectors and maturities”; (iii) has a “similar overall interest rate risk to the Lehman Brothers® 6 Month Swap Index”; and (iv) is geared toward the “preservation of capital.”  

The complaint alleges that these statements were false because “defendants did not adequately disclose the risks associated with investing in the Fund, including, for example, that the Fund was: (i) failing to compete with the Lehman Brothers® 6 Month Swap Index; and (ii) so heavily invested in high-risk mortgage-backed securities.”

I have added this case to my running tally of subprime-related litigation, which can be found here. With the addition of this lawsuit, the tally now stands at 86 subprime-related securities class action lawsuits, of which 46 have been filed in 2008.

I note that by my count, this new lawsuit represents the fourth subprime-related lawsuit against a mutual fund or mutual fund family. The other include Calamos Global Dynamic Income Fund (about which refer here), Regions Morgan Keegan Funds (refer here), and the Schwab Yield Plus Fund (refer here).

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The subprime litigation wave is growing in amplitude and volume, as four companies have found themselves the targets of a total of five new subprime-related securities class action lawsuits, joining the now quite lengthy list of companies that have been swept up in the wave. With the addition of these five new securities lawsuits, as well as the numeous other suits filed in just the last few days, it appears that the subprime litigation wave is building dangerous momentum

Wachovia:  The first of these new lawsuits was actually filed back on January 31, 2008, against Wachovia Corporation , certain of its officers and directors, a related Wachovia unit that issued certain securities involved in the lawsuit, and the offering underwriters that underwrote Wachovia’s May 2007 preferred securities offering. (As noted further below, Wachovia was also named in a separate securities lawsuit relating to auction rate securities).

The Wachovia lawsuit flew under the radar screen at the time that it was filed because the plaintiffs’ lawyers chose to file the lawsuit in New York Supreme Court (Nassau County), though the defendants have removed the action under the Securities Litigation Uniform Standards Act (SLUSA) and the Class Action Fairness Act (CAFA). A copy of the removal petition, to which the initial complaint is attached, can be found here.

The complaint assert claims based on allegedly false and misleading statements in the registration and prospectus issued in connection with Wachovia’s $750 million May 2007 offering of preferred securities. The complaint alleges that the registration statement failed to disclose that Wachovia’s "portfolio of collateralized debt obligations ("CDOs") contained billions of dollars worth of impaired and risky securities, many of which were backed by subprime mortgage loans." The complaint also alleges that the defendants failed to "properly account for highly leveraged loans such as mortgage securities." Finally, the complaint alleges that the complaint failed to disclose that Wachovia was "heavily involved in option adjustable rate mortgages (ARMs)…that would become toxic (for both Wachovia and the borrowers) once house prices stopped increasing at a rapid rate."

The complaint alleges claims only under the ’33 Act, and expressly asserts that the state court has concurrent jurisdiction under Section 22 of the ’33 Act in connection with plaintiff’s claims. The plaintiff in the Wachovia law suit seems to be pursuing the same state court strategy that I discussed at length in my prior post (here) analyzing the class action securities lawsuits that investors have filed against the securitizers who created mortgage backed assets. Significantly, the Coughlin Stoia firm is involved in both those cases and the Wachovia case. Given the sophistication of the firm involved, one must assume that these state court filings are part of a conscious strategy on the firm’s part.

Though defendants have removed the Wachovia case to the United States District Court for the Eastern District of New York, it remains to be seen whether or not the plaintiffs will be able to have the case remanded to state court. As I noted here, the plaintiffs in the Luther v. Countrywide case, a ’33 Act class action lawsuit filed against mortgage backed asset securitizers, succeeded in having their case remanded back to state court. The court in Luther case concluded that concurrent jurisdiction provisions in the ’33 Act prohibit the state court’s case’s removal to federal court.

My theory on these state court lawsuits has been that the plaintiffs intend to argue that the provisions of the PSLRA to not apply to their state court ’33 Act lawsuits. The fact that the plaintiffs’ lawyers issued no press release at the time they filed the complaint tends to reinforce this impression. But regardless of their theory they seem to be making a comprehensive effort to bring these cases in state court. The involvement of state courts in these lawsuits will be very interesting to watch.

Lehman Brothers: On February 22, 2008, a Lehman Brothers shareholder filed a purported securities class action lawsuit in the United States District Court for the Northern District of Illinois, alleging that Lehman Brothers made certain misrepresentations or omissions about its exposure to subprime mortgages during the class period from September 13, 2006 through July 30, 2007. A copy of the complaint can be found here.

There are a variety of very odd things about this lawsuit, and almost all of these odd features repeat the same odd attributes of the subprime-related securities class action lawsuit was previously filed against Morgan Stanley, as I discussed in my prior post here.

The first odd feature about this lawsuit is that it does not name the company, its directors or its senior managers as defendants in the lawsuit. The sole named defendant is the company’s Chief Financial Officer, yet no misrepresentations or omissions are attributed directly to him. The allegations against the CFO are attributed solely to his position within the company. There are no allegations that the CFO sold shares of stock. It is not particularly clear why the CFO should be named as defendant while other officials are not.

The allegations regarding the alleged misrepresentations are sparse, and are essentially limited to a few occasions when the company supposedly downplayed its exposure to subprime mortgages. The class period ends at an odd time, too; the class period end is not in January 2008, when the company said that it has lost $5.9 billion on its mortgage related positions, but on July 30, 2007, when an equity analyst downgraded the company.

The named plaintiff is also an odd representative for the purported class. Though the class period purports to run from September 13, 2006 to July 30, 2007, the named plaintiff did not even buy his shares until July 15, 2007, making him an unlikely representative for a class of that duration. Moreover, the complaint itself refers to events and statements at or about the same time that the plaintiff bought his stock which surely raised questions about subprime-related exposures in general and subprime exposures at Lehman brothers in particular.

The plaintiff also chose to file his complaint in the Northern District of Illinois, though Lehman’s headquarters are in Manhattan.

But regardless of the complaint’s numerous anomalies, the complaint does represent a subprime-related securities class action lawsuit, and so, as noted further below, I have added it to my running tally of subprime-related securities lawsuits.

Schwab: On March 18, 2008, plaintiffs filed a securities class action lawsuit in the United States District Court for the Northern District of California against the Schwab Corporation, certain of its directors and officers, and as well as the underwriter and investement adviser associated with two Schwab YieldPlus Funds. The lawsuit is filed on behalf of investors who purchased Schwab YieldPlus Investor Funds Investor Shares and Schwab YieldPlus Funds Select Shares during the period March 17, 2005 through March 18, 2008. A copy of the plaintiffs’ counsel’s press release can be found here.

The complaint alleges that the defendants issued untrue statements regarding the lack of diversification of the funds and the extent of the funds’ exposure to subprime-backed securities. The complaint alleges that while the funds advertised themselves as a safe alternative to money market funds, they were in fact critically exposed because more than 50 percent of the funds assets were invested in the mortgage industry. The plaintiffs allege that the funds have lost over 18 percent of their value since mid-2007 and 11 percent since January 2, 2008. The plaintiffs allege that the defendants violated Section 11 of the ’33 Act based in misrepresentations in the funds’ offering documents.

The Schwab funds are actually the second mutual funds to be sued in connection with the subprime crisis; as discussed here, the earlier lawsuit involved Morgan Keegan.

Special thanks to a loyal reader for copies of the Wachovia and Lehman Brothers complaints.

More Auction Rate Securities Litigation: As readers may recall, in an earlier post (here), I speculated that lawsuits related to  auction rate securities may represent the next wave in subprime securities litigation. Last week, I noted (here) the securities class action lawsuit that had been brought against Deutsche Bank on behalf of auction rate securities investors. Auction rate securities investors have now filed two additional securities class action lawsuits, one involving Wachovia, and the other involving TD Ameritrade.

With respect to TD Ameritrade, the plaintiffs filed a securities class action lawsuit in the United States District Court for the Southern District of New York on behalf of persons who purchased auction rate securities from TD Ameritrade and an affiliate between March 19 2003 and February 13, 2008 and who continued to hold the securities. A copy of the plaintiffs’ attorneys’ March 19, 2008 press release can be found here, and a copy of the complaint can be found here

The complaint alleges that the defendants failed to disclose:

(1) the auction rate securities were not cash alternatives, like money market funds, but were instead, complex, long-term financial instruments with 30 year maturity dates, or longer; (2) the auction rate securities were only liquid at the time of sale because TD Ameritrade and other broker-dealers were artificially supporting and manipulating the auction rate market to maintain the appearance of liquidity and stability; (3) TD Ameritrade and other broker-dealers routinely intervened in auctions for their own benefit, to set rates and prevent all-hold auctions and failed auctions; and (4) TD Ameritrade continued to market auction rate securities as liquid investments after it had determined that it and other broker dealers were likely to withdraw their support for the periodic auctions and that a "freeze" of the market for auction rate securities would result.

With respect to Wachovia, the plaintiffs filed a securities class action lawsuit in the United States District Court for the Southern District of New York on behalf of all investors who purchased auction rate securities from Wachovia and an affiliate between March 19, 2003 and February 13, 2008 and who continue to hold the securities. A copy of the plaintiffs’ counsel’s March 19, 2008 press release can be found here and a copy of the complaint can be found here. The allegations against Wachovia are substantially similar to the allegations against TD Ameritrade.

An additional lawsuit has been brought on behalf of an investor in auction rate securities, although in this case it is an individual action rather than a class action. On March 18, 2008, plaintiffs filed a lawsuit in the United States District Court for the Western Disrict of Texas against Wells Fargo and Wells Fargo Investments, alleging that the defendants violated the securities laws and breached their fiduciary duties in connection with the plaintiffs’ purchase of $2 million of auction rate market preferred shares. A copy of the complaint can be found here. (Hat tip to Courthouse News Service for a copy of the complaint.)

The plaintiffs contend that the Wells Fargo investment adviser referred to the securities as "bonds" that were "represented to be without risk." The plaintiffs claim that the defendants said that the securities could be redeemed on 7 days notice, but that when the plaintiffs sought to redeem the securities on March 11, 2008, they were told that no market exists for the securities. The complaint seeks recovery of $2 million plus punitive damages.

Some Observations and Tallies: Even for those that have been paying only intermittent attention, it is pretty clear that the pace of subprime-related litigation activity has picked up significantly over the last few days. Even without regard to these five new securities class action suits listed above, we had already seen a notable number of new subprime securities suits just in the last week, including for example, new lawsuits against SocGen, PMI Group, Deutsche Bank, and, most significantly, Bear Stearns. Adding these five new subprime-related securities class action lawsuits listed above to the list reinforces the impression that the litigation wave is gathering dangerous momentum, with the likelihood that even greater activity is yet to come.

With the addition of these new lawsuits to my running tally of subprime- related securities class action litigation, which can be accessed here, the current total of subprime securities lawsuits now stands at 56, of which 18 have been filed in 2008. Two of these 56 represent lawsuits by investors against mortgage backed asset securitizers, three are class action on behalf of investors in auction rate securities, and two relate to mutual funds, as noted above. The remaining 50 lawsuits were brought by shareholders of publicly traded companies.

More About Credit Default Swaps: In yet another prior post (here), I noted that problems arising from credit default swaps could be another source of litigation arising from the credit crisis. The March 20, 2008 Wall Street Journal is reporting (here) that Merrill Lynch has sued a unit of Security Capital Assurance, seeking to prevent SCA from avoiding its financial obligations to insure as much as $3.1 billion on seven credit default swaps.

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In Bear Stearns’ March 16, 2008 announcement (here) of J.P. Morgan’s acquisition of the company, Alan Schwartz, Bear’s CEO, is quoted as saying that “this transaction represents the best outcome for all our constituencies based upon the current circumstances.” Apparently, a few of those constituencies take a different view.. In addition to the securities class action lawsuits and employees’ ERISA lawsuit noted in yesterday’s post, a Bear shareholder has also filed a New York state court lawsuit (complaint here) alleging that Bear and its senior officials breached their fiduciary duty to shareholders. (Hat tip to the Courthouse News Service for the complaint.)

The relatively short complaint, which bears certain indicia of having been prepared in haste, is not presented as a derivative lawsuit, but rather as a direct claim, and is filed as a class action on behalf of all Bear shareholders. Among other things, the complaint alleges that the company “allowed itself to be sold to the lowest bidder…at the lowest possible price,” which, the complaint alleges, “is far below Bear Stearns’ value.” The complaint quotes a statement from the Wall Street Journal that the deal constitutes a "fire sale."

Schwartz’s statement that the deal was the best for “all constituencies” is noteworthy for its seeming distinction from the usual formulation that it is the obligation of a corporation’s board to maximize the interests of the shareholders. In this context, the obligations to the shareholders are usually referenced as their Revlon duties, as noted on the Delaware Corporate and Commercial Litigation blog (here). One constituency that was particularly interested in outcome of this transaction is composed of the federal regulators. Another constituency consists of Bear’s creditors and counterparties, whose anxieties apparently triggered the crisis that led to the company’s sale. These constituencies are likelier to agree with Schwartz’s characterization of the transaction.  

The constituency that consists of Bear’s shareholders, or at least the ones who have retained plaintiffs’ attorneys, see things differently. Whether or not Bear’s shareholders have a legal basis on which to protest under Delaware law is the subject of an interesting post by BYU law professor Gordon Smith on the Conglomerate blog (here). In the post, Smith refers to a prior Delaware case in which minority shareholders complained that the majority shareholder should have pursued bankruptcy rather than foreclosure (effectively, sale, as here). Smith concludes that because “there is no hint of self-dealing” in this instance, the board’s actions will be evaluated under the business judgment rule. Smith states that stockholders may be upset, “but Delaware corporate law will not come to the rescue.”

A number of other legal scholars added comments to Smith’s original post, and I recommend reading all of the comments, which are particularly interesting and thoughtful.

The Bear shareholders’ initiative to realize what they contend is (or was) Bear’s actual value may be frustrated by a quirk of Delaware law. As noted on the DealBook blog (here), because J.P. Morgan is offering stock, “there are no appraisal rights under Section 262 of the Delaware General Corporate Law Code.” If it had been a cash deal, shareholders could have gone to Delaware court for a determination of the fair value of their stock. It is in a way too bad that they cannot, because that would have made for an interesting leagl proceeding – arguably right up there with defining the value of a “burned and hairy hand.” (Readers who do not recognize this allusion should refer to the video clip below.)

As the DealBook blog details, the merger agreement (which can be found here) has a number of other interesting features, including the fact that the deal has no material adverse change clause, so J.P. Morgan has no “out.” On the other hand, Bear Stearns apparently retains what is in effect a “put,” providing Bear the right, even if Bear’s shareholder vote down the transaction, to require J.P. Morgan to reenter negotiations. (This provision may suggest one of the reasons why Bear’s shares are trading so far above the merger price – for further thoughts about which refer here..)

Readers of this blog will also be interested to note that in Section 6.6 of the merger agreement, Bear Stearns’ directors and officers are entitled to six years of tail D & O coverage. (All of those insurance markets clamoring to provide the tail coverage should form an orderly line, please.). In addition, Bear’s directors and officers are given full indemnification from J.P. Morgan. I suspect these provisions, and especially the J.P. Morgan indemnity, were particularly attractive to the Bear Stearns senior officials involved in the negotiations. While one might suppose that the very attractiveness of the indemnity put the Bear Stearns officials in a potentially conflicted position (as the terms represented a form of consideration valuable to the officials but not to Bear’s shareholders), in the end the J.P. Morgan indemnity might prove quite valuable to Bear’s shareholders in a roundabout sort of way, if you follow my drift….

In any event, it may come as little surprise that the SEC is reportedly investigating trading ahead of Bear’s collapse last Friday. According to a March 18, 2008 Bloomberg.com article (here), “U.S. regulators are investigating whether traders illegally sought to force Bear Stearns Cos. shares into a tailspin last week by spreading false information about the firm's finances.”

For its part, the SEC released today “Answers to Frequently Asked Questions Concerning The Bear Stearns Companies, Inc.” (here), which, among other things explains the role of the SEC staff in the Bear Stearns/J.P. Morgan transaction.

More About Credit Default Swaps: In an earlier post (here), I wrote about the rising litigation threat from credit default swap transactions, particularly due to the growing counterparty risk. A March 17, 2008 Time.com article entitled “Credit Default Swaps: The Next Crisis?” (here) takes a closer look at CDSs and concludes that the instruments “could soon become the eye of the credit hurricane.”

Among other things, the article notes that the market for these instruments exploded to $45 trillion in mid-2007 – by contrast to the mortgage market, which is “only” $7.1 trillion. The article details the conditions that have rattled the marketplace, and concludes that the “potential repercussions are far-reaching.”

Those prone to concerns that we could be facing a period of significant economic adversity may be reassured that we have many safeguards in place that did not exist, for example, in 1929 and 1930. But, as the article concludes, none of these safeguards “are directly targeted at CDS.”

More About Foreign Litigants: In earlier posts (refer here), I have discussed the problem of foreign litigations who purchased their shares in foreign companies on foreign exchanges (the so-called “f-cubed” litigants) who are suing the foreign companies in U.S court under U.S. securities laws. In a recent post on the Securities Litigation Watch blog (here), Adam Savett takes a look at the recent decision in the Converium case, in which the court denied class certification to all putative class members who were neither U.S. citizens nor purchased shares on U.S. exchanges. As I noted on post discussing the recent U.S lawsuits filed against SocGen, it appears that the plaintiffs’ counsel in that case conformed their putative class to conform to the limitations adopted by the Converium court.

Break in the Action: The D & O Diary will be on a reduced publication schedule for the next few days. We will resume our normal publication schedule some time after March 25.

A Burned and Hairy Hand:: The reference above to “the value of a burned and hairy hand,” is an allusion to the standard Contracts law case of Hawkins v. McGee, a case made famous (or perhaps infamous) in the classic scene from the movie The Paper Chase. I suspect that few law students have actually endured anything like this famous scene (I actually enjoyed law school), but for some reason the scene has become an archetypical representation of the legal classroom. Here is Professor Kingsfield in all of his sadistic glory:

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Add credit default swap counterparty litigation to the growing list of subprime-related litigation categories.

Credit default swaps have, of course, already been drawn into the subprime litigation wave to a certain extent. For example, as I previously noted (here), Swiss Re has been sued in a subprime related securities lawsuit in connection with its write-down in the valuation of certain credit default swaps. And I also previously noted (here) litigation between an institutional CDO investor and the CDO originator where the investor also had credit default obligations for the CDO.

But according to news reports earlier this week (here), Citibank and Wachovia have each been sued in separate lawsuits brought by a credit default swap counterparty. A closer look at the pleadings in the lawsuits suggests we may be seeing a great deal more of this kind of litigation ahead.

First, some definitions.  As explained in Wikipedia (here), a credit default swap is an agreement between two parties under which one party (the seller) agrees, in exchange for a periodic payment, to provide the buyer with protection in the event of a default or other credit event involving an underlying instrument. A credit default swap is like insurance, except that there is no requirement that the buyer actually hold the underlying instrument, so credit default swaps are often used as a means so speculate on interest spreads.

Both Citigroup and Wachovia entered credit default swaps with a hedge fund incorporated in the Bailiwick of Jersey (one of the Channel Islands) The hedge fund, previously known as CDO Master Fund Ltd., is now known as VCG Special Opportunities Master Fund Limited. During 2007, the hedge fund entered two credit default swaps, one with Citibank and one with Wachovia, that are now the subject of litigation.

According to the hedge fund’s January 12, 2008 Amended Complaint against Wachovia (here), on May 21, 2007, the hedge fund entered a $10 million credit default swap with Wachovia in connection with a Class B tranche of a collateralized debt obligation. The hedge fund was to be paid a 2.75% per annum fee for the swap, to be secured by a deposit of $750,000. According to the hedge fund’s allegations, during the course of 2007, Wachovia demanded that increasing amounts of collateral, which by November 2007 cumulated to an amount in excess of the swap’s notional $10 million face value.

The hedge fund kept pace with the demands for additional collateral until the demands exceeded $8,920,000, at which point the hedge fund initiated the dispute resolution mechanisms in the agreement, and ultimately initiated litigation in New York Supreme Court, which Wachovia removed to federal court.

The hedge fund contests that there has been an event of default or any other event that would trigger their payment obligation under the swap. Wachovia for its part submitted a notice of termination, foreclosed on the collateral, and counterclaimed (here) against the hedge fund for the “deficiency.” Wachovia bases its justification for the demands for the increased collateral on the absence of any commercial market for the CDO. The hedge fund’s lawsuit seeks to rescind the swap, on the grounds of fraud and mistake; and also seeks damages for fraud, breach of contract and breach of the covenant of good faith and fair dealing; and unjust enrichment. Wachovia’s counterclaim alleges breach of contract.

The hedge fund’s lawsuit with Citibank is based on more or less the same dispute, albeit in connection with a different credit default swap. According to the hedge fund’s February 14, 2008 complaint (here), the notional value of the Citibank default swap was also $10 million, and Citibank ultimately “extracted” (according to the complaint) collateral of $9,960,000 from the hedge fund. 

There are a number of interesting things about these circumstances. Perhaps the most interesting is that according to the complaints, the hedge fund has approximately $50 million of capital under management. In other words, the notional amount of just these two swap contracts alone represented 40% of the hedge fund’s capital. I am going to go out on a limb and guess that the hedge fund had other contracts too. But whether or not the hedge fund had other contracts, it is hardly surprising that, given its limited capital,  the hedge fund reached a point where litigation seemed like a better option than any further collateral advances; the fund’s managers may have decided they had nothing to lose by fighting

But even more interesting than the hedge fund’s huge vulnerability to just these two transactions is the fact that a couple of major financial players like Wachovia and Citibank were accepting what amounts to insurance from a thinly capitalized pocket portfolio incorporated in the Bailiwick of Jersey. Certainly if they had been placing insurance as such they would never in a million years have transacted with an offshore insurer whose total capital was both so small and such a small percentage of the exposure. Perhaps a belated realization of these shortcomings explains the banks’ demands for additional collateral…

But whatever may have led two of the world’s largest banks to accept guarantees from a small, thinly capitalized hedge fund, these circumstances at a minimum demonstrate something that I suspect we will be reading about a lot more in the coming days – that is, “counterparty risk.”

There are several important things to be recognized about counterparty risk. The first is that it is not a prerequisite to a credit default swap transaction that either party holds the instrument to which the swap relates. The practical consequence of this fact is that the aggregate notional value of all swaps in force far exceeds the value of the underlying instruments. Here’s a number that we all need to contemplate – according to the Wall Street Journal’s March 4, 2008 article (here) about the above-described litigation, the market for swaps totals $45 trillion (that’s trillion with a “t”), an amount that is “comparable to all the bank deposits world wide.” That, my friends, represents a whole lot of counterparty risk.

Another important thing to be recognized about counterparty risk is that, according to the Journal article, hedge funds have in recent years become the predominant players in this market. The Journal says that hedge funds accounted for 60% of the credit default swap trading in high-grade debt and 80% of the low grade debt in the 12 months ending in April 2007.

While many of the hedge funds involved in this marketplace may be better capitalized than the hedge fund described above, the very fact that two banks like Wachovia and Citibank dealt with this fund at all, despite the low ratio of its capital to the notional value of the swap transaction, suggests that a certain amount of business (who knows, perhaps a considerable amount of business) involved hedge funds, and perhaps others, who like the hedge fund described above, will be challenged to respond to calls for additional collateral.

The same turmoil that caused Wachovia and Citibank to call for additional collateral in these transactions is undoubtedly resulting in countless similar communications throughout the marketplace. The longer the disruption in the underlying marketplace continues, the more abrupt the calls will be. The pressures that the principal firms face to protect their own balance sheets adds greater urgency to each of those calls. And the previously hidden but now revealed demon within each transaction motivating those calls is the suddenly frightening prospect of counterparty risk. The particularly frightening aspect of these circumstances is that all of the calls are going out more or less simultaneously – and counterparties with limited capital will find themselves forced against the same wall as the hedge fund described above.

The litigation will be bad. The financial consequences could be worse.

Indispensible Reading: The best way I can think of to end this really depressing blog post is to reward everyone who has read this far and suggest that the best way to put the circumstances described above in context is to read University of Virginia Graduate Business School Professors’ Robert Bruner and Sean Carr’s eminently readable and deeply thought-provoking book, The Panic of 1907 (refer here for more information).

Even though their book describes circumstances from a century ago, there is a chillingly familiar resonance to the events addressed in their book. Among other things, in their efforts to explain how financial panics arise, the professors describe the following factors:

It begins with a highly complex financial system, whose complexity makes it difficult for anyone to know what might be going wrong; by definition, the multiple parts of the financial system are linked, which means that trouble in one institution, city, or region can travel easily and quickly to others. Buoyant growth in the economy makes the financial system more fragile, in part due to the demand for capital and in part due to the tendency of some institutions to take on more risk than is prudent. Leaders in government and the financial sector implement policies that advertently or inadvertently elevate the exposure to risk of crisis. An economic shock hits the financial system. The mood of the market swings from optimism to pessimism, creating a self-reinforcing downward spiral. Collective action by leaders can arrest the spiral, though the speed and effectiveness with which they act ultimately determines the length and severity of the crisis.

Read the book. It is worth reading in and of itself, but under the present circumstances, the book is simply indispensible.

A very grateful hat tip to Floyd Norris, of the New York Times (whose column, here, discussed the Panic of 1907) and whose blog, Notions of High and Low Finance (here), specifically referenced the professors’ book.  

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New York Subprime Lawsuit Between Two Foreign Banks: As I noted in prior posts (most recently here), mortgage-backed securities investors have already initiated several lawsuits against the investment banks and others that created the securities, some lawsuits filed as individual actions and some as class actions. A mortgage-backed securities investor’s individual lawsuit initiated this week in New York Supreme Court (Manhattan) presents some new twists on this evolving litigation category.

According to the company’s press release (here), on February 25, 2008, German state-owned bank HSH Nordbank AG sued UBS and UBS Securities LLC. The lawsuit relates to one of HSH’s constituent bank’s $500 million investment in 2002 in collateralized debt obligation (CDO) securities known as North Street 2002-4 that were created and managed by the Swiss bank. In its complaint, HSH described itself as a “regional German bank with little familiarity with international structured finance.” As described in a February 25, 2008 Wall Street Journal article (here), the HSH relation with UBS was “more complicated” because in addition to its investment in the CDO, HSH also provided UBS with insurance protection in the form of credit default swaps.  

As reflected in news coverage describing the complaint (here and here), HSH claims that UBS’s now-shuttered internal hedge fund division, Dillon Read Capital Management, selected inferior collateral and used the CDO as a dumping ground for troubled mortgage-backed securities as a way to profit from the credit default swap.

The complaint alleges that during 2007 Dillon Read made substitutions to the “reference pool” of securities linked to the CDO, bringing in securities lined to the ABX index of subprime mortgage instruments, thereby allegedly increasing the CDOs exposure to subprime mortgages “at a time when the outlook on subprime mortgages was already negative.”

HSHS claims that the structure, and in particular its position on the credit default swap, allowed UBS to realize profits of up to $275 million at HSH’s expense. As also reflected in the bank’s February 24 press release (here), HSH alleged that “UBS exploited the structure for its own ends, at HSH’s expense,” and that “UBS evidently regarded North Street 4 not as an investment platform but as an opportunity to defraud HSH.”

HSH alleges that UBS “knowingly and deliberately created a compromised structure.” HSH accuses UBS of breach of contract, fraud, negligent misrepresentation, and breach of fiduciary duty.” HSH is demanding at least $275 million in restitution plus punitive damages.

There are several interesting things about this new lawsuit. The first is that it involved a New York state court lawsuit between two foreign-domiciled companies. This may be due in part to the role played by the now defunct UBS affiliate Dillon Read. But an even likelier explanation is the prospect of the remedies available under U.S. laws, which undoubtedly influenced HSH to pursue its claims in what would otherwise seem to be an inconvenient forum. It is, in any event, singular to find two foreign companies squaring off in a U.S courthouse.

The availability of alternative dispute resolution forums in which the case might also have gone forward may be seen from the fact that UBS itself has already filed a counterclaim against HSH, but (as reflected here), in London rather than in New York. According to news reports, the counterclaim itself has not been made available publicly.

Perhaps the most interesting thing about the HSH lawsuit is the core allegation. The prior lawsuits against the securitizers have essentially been disclosure-based lawsuits, in effect that the securitizers did not provide full or accurate information about the securities they initiated or about the assets underlying the securities. HSH’s complaint also contains these kinds of allegations, but the core of its complaint is not mere misrepresentation, but rather that UBS fraudulently manipulated the transaction structure to its own profit and to the investors’ detriment. These kinds of allegations clearly raise the stakes, and make this case most interesting to watch.

Finally, this is the first subprime-related case of which I am aware between counterparties on credit default swaps. Given the massive volume of credit default swap activity, there is an enormous potential for credit default swap counterparty litigation.

More Auction Rate Securities Write-Downs: In a prior post (here), I discussed the $275 million write-down that Bristol-Myers Squibb took related to its investment in auction rate securities. At the time, I wondered whether other companies would face similar write-downs, with particular interest in the possible impact on companies outside the financial sector.

At least two other nonfinancial companies have now taken their own subprime-backed asset write-downs, in examples that underscore that impact that the breakdown of the auction rate securities market is having on the value of those securities. These write-downs also highlight the fact that the impact of the subprime meltdown extends far beyond the financial sector.

On February 27, 2008, MetroPCS announced (here) in connection with its fourth quarter earnings release that it had recorded a fourth quarter charge of $83 million in unrealized loss on its $134 investment in auction rate securities. Including the company’s $15 million third-quarter write-down, the year-end value of its $134 investment was at $36 million. As I discussed in a prior post (here), MetroPCS has filed a lawsuit against Merrill Lynch in connection with the company’s investment in the auction rate securities. A copy of the complaint can be found here. It is worth noting that company’s reported fourth quarter loss of $47 million included the $83 million impairment charge.

And on February 21, 2008, SBA Communications reported (here) an impairment charge of $15.6 million on three auction rate securities the company held as short term investments. The company’s net loss for the quarter was $24.2 million including the asset impairment charge.

A February 27, 2007 CFO.com article discussing the MetroPCS write-down can be found here. A February 22, 2008 CFO.com article discussing the SBA Communications write-down can be found here.

Got Those Valuation Blues Again, Mama: A February 24, 2008 post on the Re:Balance blog (here) takes a look at the accounting and valuation issues arising out of the subprime crisis, and suggests that the mortgage asset-backed securities valuation problems that are currently emerging are not merely an attribute of the current disrupted market conditions but were inherent in the terms of the instruments at the time they were created.

Jim Peterson, the blog’s author, writes “the more candor and rigor are brought into this year’s audit process, the more stark will be the ultimate concession that the valuation models on which subprime was built were creatures of myth and unreality.” Peterson, who is the accounting columnist for the International Herald Tribune, adds that “the quality of accounting is an effect, not a cause – the level of its virtue and integrity is observable as a mirror held up to commercial society.”

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On February 27, 2007, plaintiffs’ lawyers’ initiated a securities class action lawsuit in the United States District Court for the Southern District of New York against Swiss Reinsurance Company, the world’s largest reinsurance company, and certain of its directors and officers. A copy of the plaintiffs’ lawyers’ press release can be found here and a copy of the complaint can be found here.

The lawsuit relates to the company’s November 19, 2007 announcement (here) of a 1.2 billion Swiss Franc mark-to-market loss on the two related credit default swaps the company had issued to provide loss protection against certain asset backed securities.

According to the plaintiffs’ attorneys’ press release,

The complaint alleges that during the Class Period, defendants made false and misleading statements about the Company’s financial condition. Specifically, defendants failed to disclose that Swiss Re’s Credit Solutions unit had written two credit default swaps that exposed the Company to great financial risk. In a credit default swap, one party guarantees that a third party borrower will not default on a debt. In this case, Swiss Re guaranteed certain mortgage-backed securities which included some subprime and collateralized debt obligations. When the existence and nature of the credit default swaps was disclosed, Swiss Re’s stock price dropped from CHF97.55 to CHF87.55 (Swiss Francs) the next day.

The complaint particularly emphasizes that the November 19 announcement came just days after the company’s November 6, 2007 third quarter earnings release (here), which did not mention the credit default swap write-off but contained certain representations about the company’s exposure to subprime issues.

There are several interesting things about this lawsuit. While this is not the first lawsuit filed against companies that provided default guarantee protection to subprime securities, the prior companies to be sued in this regard have been the bond insurers whose primary business is providing default protection. As far as I know, the Swiss Re lawsuit is the first lawsuit against a company specifically linked to the issuance of credit default swaps guaranteeing against the default of subprime-related securities. There have been other companies that have announced accounting write-downs in connection with credit default swaps (see, for example, AIG’s recent announcement here), and there undoubtedly will be others – just as there undoubtedly will be other lawsuits in relating to credit default swaps issued on mortgage-backed assets.

The second interesting thing about this suit is who the plaintiff is – the plaintiff is the Plumbers’ Union Local No. 12 Pension Fund, on whose behalf the same law firm (Coughlin Stoia) previously filed a securities class action lawsuit against Nomura Asset Acceptance Corporation and related entities, as discussed in my recent post here. This union fund certainly does seem to have had some remarkably bad luck with its investments as a result of the subprime meltdown. It also seems to have a durable client-attorney relationship with the Coughlin Stoia firm.

The third interesting thing about this lawsuit is that it comes more than three months after Swiss Re’s November 19 announcement. Up to this point, the subprime related lawsuits have followed pretty closely in the wake of disclosure of subprime related accounting adjustments. The delay in filing this lawsuit suggests that the "moping up" exercise may have begun – that is, the process of going back and combing over the prospective claims that might have been missed the first time through. There certainly have been a host of companies who have made fairly significant announcements over the last few months who have not yet been sued. Their date may yet be coming.

It is interesting in another respect that this lawsuit has arisen now. The company got a boost even after write down when on January 23, 2008 it announced (here) that Berkshire Hathaway had taken a 3% interest in the company and would be taking 20% of the company’s property and casualty reinsurance business over the next five years. This seeming validation from the sage of Omaha may not have been enough to mollify at least some investors, apparently.

I have in any event added the Swiss Re case to my running tally of the subprime-related securities lawsuits, which can be found here. The addition of the Swiss Re case brings the total count of subprime securities lawsuits to 47, eight of which have been filed in 2008. As I noted above, the Swiss Re case is to the best of my knowledge the first subprime related lawsuit based on the loss in value of credit default swaps; it seems prudent to assume at this point that there will be more to come.

Everyone Remain Calm: The subprime crisis not only threatens financial losses, it apparently could also hazard a massive loss of life. According to a February 26, 2008 Financial Times article entitled "Banking Crises Shown to Trigger Heart Attack Deaths" (here), between 1,300 and 5,100 people could die if "a significant proportion of banks suffered crises similar to that at North Rock.

Cambridge University researchers studied 40 years of data from the World Bank and the World Health Organizations, and concluded that "system-wide" crises increase average deaths from heart disease an average of 6.4 percent in wealthy countries – and more in developing countries. Researchers warn that a global banking crisis "would kill tens of thousands of people by heart attacks brought on by stress and anxiety." One of the researchers noted that "containing hysteria and preventing widespread panic is important not only to stop these incidents leading to a systemic banking crisis but also to prevent thousands of heart disease deaths."

More About Subprime: Just a reminder that Mealey's is sponsoring a Subprime-Backed Securities Litigation Conference on March 6, 2008 at the Harvard Club in New York City. The conference is to be chaired by David Grais of the Grais & Ellsworth firm. I will be speaking on the topic of "CDOs, Asset Valuation and the Subprime Litigation So Far." A copy of the conference brochure can be found here.

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