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

By now you will have heard that the U.S. Department of Justice has filed a securities class action lawsuit against S&P and its corporate parent, McGraw-Hill, about the rating agency’s  ratings of collateralized debt obligations as the subprime meltdown unfolded. A copy of the DoJ’s complaint, filed on February 4, 2013 in the Central District of California, can be found here.

The complaint has attracted widespread media attention, as well it should, since it represents that government’s first action against a rating agency in connection with the subprime meltdown and the credit crisis But there are a number of interesting features to this action, beyond just the fact that the DoJ has filed a lawsuit against a rating agency.

First, there’s the fact that the lawsuit was filed in the Central District of California, rather than in New York, where S&P is located. To the extent that the complaint supplies an answer for the choice of venue question, it appears that the DoJ chose the C.D. Cal. because that is where the failed Western Federal Corporate Credit Union was located. As is alleged in the complaint, the failed credit union was apparently an investor in a number of the specific CDOs mentioned in the complaint. Many of these investments resulted in a total loss to the credit union. More broadly, the DoJ alleges that the S&P engaged in a scheme to “defraud investors.” The specific investors mentioned by name in the complaint area all federally insured depositary institutions.

The second interesting thing about the complaint is that thought it was filed by the Department of Justice, it has been filed as a civil action, presumably because the DoJ feels stands a better chance of success with the lower standard of proof applicable in a civil case. But though the case was filed as a civil action, the claims asserted are a little unexpected (at least to me). The DoJ asserts substantive claims for wire fraud, mail fraud, and two counts of financial institution fraud under the Financial Institutions Reform, Recovery and Enforcement Act of 1989 (“FIRREA”).

In its February 4, 2013 press release about the then-anticipated law suit, S&P characterizes  the DoJ’s use of FIRREA as a “questionable legal strategy” intended as an attempt to “end run” the “well-established legal precedent “ on which the defendants hope to rely. Presumably, the reference to the established precedent refers to case law finding that that rating agency’s opinions represent opinion protected under the first amendment.

I suspect a different explanation for the DoJ’s reliance on FIRREA. The fact is, many of the events described in the complaint took place many years ago, in some instances six years ago or more. The DoJ is rightly worried about possible statute of limitations concerns. That’s where FIRREA comes in. FIRREA has a ten-year statute of limitations for a violation of, or a conspiracy to violate, the mail or wire fraud statutes, if the offense affects a financial institution (about which refer here). The defendants undoubtedly will try to raise a host of defenses, but the DoJ doesn’t want statute of limitations issues to cut the action short.

Third, the complaint names as defendants only S&P and its corporate parent. None of the other rating agencies are named – a point that gripes S&P. In its February 5, 2013 press release, issued after the complaint was filed, S&P notes that “every CDO cited by the DoJ also independently received the same rating from another rating agency.” It may simply be that S&P is up first and the other rating agencies’ turn is coming. However, another possibility may be that the DoJ had more to work with against S&P, particularly from the apparent treasure trove of emails that are liberally quoted in the complaint.

The complaint paints a very detailed picture of the dynamic inside S&P as it became increasingly apparent in early 2007 that residential mortgages originated in 2006 were failing quickly, particularly with respect to subprime and Alt-A mortgages. It is clear that S&P felt under a great deal of pressure not to move any more quickly than its competitors for fear of losing business. The warning signs appeared to accumulate as 2007 unfolded while at the same time the issuers who sought out S&P’s ratings were scrambling to complete offering s, to get mortgage backed securities out of their warehouse. The emails and other internal communications (at least as portrayed in DoJ’s complaint) seem to show a sequence of events where alarm bells were sounding louder yet deals continued to get pushed through.

As things deteriorated, a gallows humor seems to have set in, provoking a number of emails in which S&P staffers apparently acknowledged the growing problems. As quoted in detail in this February 5, 2013 Business Insider column (here), the emails show an apparent perception on the part of at least some S&P staff that the firm was compromising its rating standards under pressure from issuers. The emails include the now-infamous email in which one staffer quipped that a transaction could be “structure by cows” and the firm would still rate it. Another email exchange between an analyst and an investment banker outside the firm about how the MBS world is “crashing” and the firm is running around to “save face.”

Another analyst sent an email with a spoof version of Talking Heads’ classic hit, “Burning Down the House,” including lyrics that “huge delinquencies” in the 2006 vintage were “bringing down the house.” The complaint alleges that shortly after this first email, the same analyst sent an email with a video of the analyst singing the first verse of the spoof for an audience of laughing S&P staffers. (More about the surprise appearance from the Talking Heads in the DoJ’s complaint here.)

Whatever may be the reasons why the DoJ decided to proceed under FIRREA and to sue only S&P, the agency will still have to contend with the argument that the rating agency’s ratings are inactionable opinion or are protected by the First Amendment – arguments that the Sixth Circuit appeared to validate in its December 2012 opinion dismissing actions that the Ohio Attorney General filed against the rating agencies on behalf of Ohio state employee pension funds.

Time will tell how the DoJ attempts to address these arguments, but it appears from the agency’s complaint that the agency will be attempting to argue that S&P is not entitled to rely on these defenses because the ratings did not represent the rating agency’s opinions. The complaint alleges that the rating agency “falsely represented” that the ratings “reflected S&P’s true opinion” regarding the credit risks the complex securities represented to investors.  The DoJ may be poised to argue that the alleged misrepresentations on which its claims are based are not the opinions themselves but rather the rating firm’s statements about its process and the integrity of its process.

One final question is why is the government acting now, years after the crash and years after the events described in the complaint? Several media reports suggested that the DoJ acted only after attempts to work out a negotiated settlement failed. One of the S&P’s lawyers tried to suggest on CNBC that the government investigation intensified after the rating firm downgraded the U.S.’s debt. What ever the reason that the complaint is only being filed now, if nothing else the complaint does show that we are continuing to live with the fallout from the credit crisis and the issues from the crisis are going to be litigated for some time to come.

Alison Frankel has a good summary of the complaint and its allegations in her February 5, 2013 post on her On the Case blog (here).

Special thanks to the several readers who sent me a copy of the DoJ’s complaint.

And Finally: With a hat tip to the Business Insider article linked above, here is the original video version of “Burning Down the House”

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On August 23, 2011, a three-judge panel of the Second Circuit in an opinion by Judge Barrington D. Parker affirmed the dismissal of the subprime-related securities lawsuit that had been brought against Regional Financial Corporation and certain of its directors and officers. A copy of the Second Circuit’s opinion can be found here.

Background

As reflected in greater detail here, the plaintiffs first filed a securities class action lawsuit in the Southern District of New York against Regions on April 1, 2009. The plaintiffs represented investors that had purchased securities in the company’s $345 million April 2008 trust preferred securities offering. The defendants included the company, certain of its directors and officers, its offering underwriters, and its auditor.

The plaintiffs alleged that the April 2008 offering documents were false and misleading because they incorporated by reference financial statements that overstated goodwill associated with Regions Financial’s 2006 acquisition of AmSouth and underestimated loan loss reserves associated with the AmSouth’s declining mortgage lending porfolio. Among the financial statements incorporated into the offering documents was the company’s 2007 Form 10-K.

The complaint alleged that the company "did not write down any of the massive goodwill" it recorded in its 2007 10-K "despite growing evidence indicating that serious problems existed at the time of the acquisition." The complaint also alleges that Regions "only marginally increased its loan loss reserves" despite "the high risk of loss inherent in its mortgage loan portfolio." The defendants moved to dismiss on the grounds that the plaintiffs had failed to allege any actionable misstatements or omissions.

As discussed here, in a May 10, 2010 opinion, Southern District of New York Judge Lewis Kaplan granted the defendants’ motions to dismiss, holding that the statement about goodwill and the loan loss reserves represented opinions that were not actionable because the complaint failed to allege that defendants did not honestly hold those opinions at the time they were expressed. The plaintiffs appealed.

The Second Circuit’s Opinion

The Second Circuit affirmed Judge Kaplan’s dismissal of the trust preferred securities investors’ securities lawsuit. With respect to the allegations regarding the statement concerning goodwill, the Second Circuit observed that “as Judge Kaplan correctly recognized, plaintiffs’ allegations regarding goodwill do not involve misstatements or omissions of material fact, but rather a misstatement regarding Regions’ opinions.”

In concluding that the plaintiffs had not adequately alleged actionable misstatements regarding misstatements or omissions regarding goodwill, the court said that

Plaintiff relies mainly on allegations about adverse market conditions to support the contention that defendants should have reached different conclusions about the amount of and the need to test for goodwill. The complaint does not, however, plausibly allege that defendants did not believe that statements regarding goodwill at the time they made them.

The Second Circuit went on to conclude that the plaintiffs’ allegations regarding loan loss reserves “suffer from the same deficiencies as those regarding goodwill.” The court approvingly cited Judge Kaplan’s statement that “determining the adequacy of loan loss reserves is not a matter of objective fact”; rather, loan loss reserves “reflect management’s opinion or judgment about what, if any, portion of amounts due on the loans ultimately might not be collectible.” Because the plaintiff failed to allege that the defendants’ opinions were “both false and not honestly believed when they were made,” the loan loss reserve allegations also fail to state a claim.

Discussion

The Second Circuit’s opinion in the Regions case is the latest in a series of decisions in which the appellate courts have affirmed the district court’s dismissals of subprime or credit crisis-related securities class action lawsuits. Earlier example include the NovaStar Financial case (about which refer here), the Centerline Holdings case (refer here),  the Impac Mortgage Holdings case (refer here) and the HomeBanc case (refer here).  At this point, it seems clear the appellate courts are reluctant to setting aside the dismissal motion rulings of the district courts in these cases.

What makes the Regions Financial trust preferred securities case noteworthy and even interesting is that the case was dismissed, and the dismissal was affirmed, while related complaints involving many of the same facts have actually survived dismissal motions. In particular and as noted here, in June 2011, Northern District of Alabama Judge Inge Prytz Johnson denied the motions to dismiss in the securities class action lawsuit filed on behalf of Regions Financial’s shareholders.

The Northern District of Alabama lawsuit also alleges that the company had failed to recognize the impairment of the goodwill associated with the AmSouth merger. As I discussed in my prior post about Judge Johnson’s ruling, she expressly recognized that Judge Kaplan had previously dismissed the Southern District of New York lawsuit filed on behalf of the trust preferred securities investors. However, she differentiated the allegations in the case in her court based on the plaintiffs’ allegations made based on the statements of confidential witnesses.

Judge Johnson concluded that the plaintiffs in the case before her have “pled many facts showing that the defendants had information that did not support defendants’ opinions.” Among other things, she cited the statements of the confidential witnesses “showing how defendants improperly handled and classified loans, defendants were aware of the collapsing commercial real estate in Florida yet continued to push for more growth there, and continued to ignore [internal] reports signaling a negative risk-adjusted bottom line.

Judge Johnson concluded that the plaintiffs has sufficiently alleged that the company’s loan loss reserves were false and misleading, citing the testimony of several confidential witnesses that “defendants mishandled loans in order to manipulate their financial reporting numbers.” Because the loan loss reserves impacted the company’s reported income (which was the measure by which the company tested its goodwill), Judge Johnson concluded that the plaintiffs had adequately alleged that the company’s goodwill was “overstated, false and misleading.”

On August 23, 2011, Judge Johnson denied the defendants' motion for reconsideration, rejecting the defendants' argument that the Supreme Court's recent decision in the Janus Capital case required a different result. Judge Johnson's August 23 order can be found here.

In addition, and as noted here, the plaintiffs in the separate shareholders’ derivative lawsuit filed in Alabama Circuit Court against Regions Financial, as nominal defendant, and certain of its directors and officers, also survived a motion to dismiss. However, it should be noted that the Alabama court was determining only whether or not the requirement for pre-suit demand was excused based on the circumstances alleged.

Finally, and just to complete the picture, in March 2010, the motions to dismiss was also denied in the Regions Financial ERISA action, about which refer here.

While the differences in the outcome between the New York lawsuit and the other lawsuits can be accounted for based on differences in the claims asserted and the specific matters alleged, there is also a sense in reading through all of these opinions that the outcomes may also be understood based on the respective court’s starting points. As I noted in my prior posts discussing the prior dismissal motions denials, for the other judges, the context matters, but for Judge Kaplan (and now for the Second Circuit) the context is irrelevant. There is also a sense that the more geographically proximate the decisions maker to the locus of the corporate defendant and its woes, the less sympathetic the courts are to the defendants’ position.

In any event, I have adjusted my tally of the dismissal motion rulings in subprime-related securities suits to reflect the Second Circuit’s opinion. The tally can be accessed here.

Special thanks to Douglas Henkin of the Milbank law firm for providing me with a copy of the Second Circuit’s opinion. Milbank represented the Underwriter defendants before the Second Circuit.

Deutsche Bank Subprime-Related Securities Suit Survives Dismissal Motion Ruling: In an August 19, 2011 opinion, here, Southern District of New York Judge Deborah Batts largely denied the motion to dismiss in the subprime-related securities suit filed against Deutsche Bank and certain of its directors and officers.

As discussed here, several groups of investors, who had purchased Deutsche shares in a series of offerings during the period 2005 to 2007, filed lawsuits asserting claims that the offering materials contained material misrepresentations and omissions in the associated offering documents. The plaintiffs basically alleged that the bank had misrepresented its exposure to residential mortgage backed securities and collateralized debt obligations. The various cases were later consolidated before Judge Batts and the defendants moved to dismiss.

In her August 19 order, Judge Batts granted the motion to dismiss as to stock offering from October 2006. However, Batts left intact claims relating to five other offerings, or gave the plaintiffs a chance to replead their allegations.

I have also added the Deutsche Bank decision to my tally of subprime related dismissal motion rulings.

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In the latest ruling on a motion to dismiss in a subprime-related securities lawsuit, on December 22, 2008, Judge Legrome Davis of the Eastern District of Pennsylvania granted in part and denied in part defendants’ motion to dismiss the suit that plaintiffs’ filed in August 2007 against RAIT Financial Trust and certain of its officers and trustees. The opinion can be found here.

Judge Davis’s ruling largely denied defendants’ motions, other than with respect to the plaintiffs’ ’33 Act claims concerning the company’s July 2007 secondary offering, which were dismissed due to the plaintiffs’ lack of standing. Otherwise, Judge Davis ruled in plaintiffs favor. The plaintiffs’ remaining ’33 Act claims and all of the plaintiffs’ ’34 Act claims will now go forward.

Background

RAIT is a real estate investment trust providing debt financing to home builders, mortgage lenders and other real estate companies. As more fully set forth here, plaintiffs’ complaint relates to the July 30, 2007 failure of American Home Mortgage to make a payment due under certain trust preferred securities, resulting in a net equity exposure to RAIT of at least $95 million. Shortly thereafter, the company disclosed that it had $373 million of similar exposures. The plaintiffs allege that the defendants failed to disclose its exposure to these types of investments and failed to reserve adequately for the risk of nonpayment or default.

The plaintiffs’ complaint asserts claims under both the ’33 Act and the ’34 Act. The defendants in the ’33 Act claims include the offering underwriters that facilitated RAIT’s January 2007 common stock offering and July 2007 preferred stock offering, as well as the company’s auditor, Grant Thornton. The defendants’ moved to dismiss.

The December 22 Opinion

First, the court dismissed the ’33 Act claims relating to the July 2007 preferred stock offering due to lack of standing, because none of the named plaintiffs purchased securities traceable to the offering.

However, the court denied the defendants’ motion to dismiss the ’33 Act claims raised in connection with the January 2007 offering. Judge Davis found that the plaintiffs had adequately alleged falsity and materiality, and rejected defendants’ contentions that the plaintiffs’ arguments represented nothing more than "fraud by hindsight." Judge Davis also rejected the defendants’ contentions that the alleged misrepresentations "bespoke caution" or were "mere puffery."

Judge Davis also found that his rulings that the plaintiffs had adequately pled falsity and materiality applied to the plaintiffs’ ’34 Act claims as well.The defendants nevertheless sought to have the ’34 Act claims dismissed, arguing that the plaintiffs had not adequately pled scienter.

Judge Davis found that "despite the demanding standard of recklessness imposed in pleading a strong inference of scienter," the plaintiffs nevertheless had adequately pled scienter. His ruling depended on the "core business operations" theory, with respect to which he stated:

Because the alleged misstatements involved RAIT’s core business operations and because the Officer Defendants had ample reason to know of the falsity of the statements, there is a strong inference of scienter in this case.

Judge Davis also found that though the core business operations allegations alone were sufficient, other allegations also supported the inference of scienter, including "the sheer size of the impairment eventually taken by RAIT," which he found adds to "the imputation" that defendants "must have had some awareness that problems were brewing." Judge Davis also found that "familial and business relationships involved" in a RAIT acquisition were "relevant in our consideration of scienter."

Discussion

Other than the ’33 Act claims relating to the July 2007 offering (which was dismissed for lack of standing), the plaintiffs largely prevailed on the dismissal motions. Judge Davis’s ruling is significant not only because it seems to run counter to the early trend other courts arguably have established (albeit with some notable exceptions) of general skepticism toward subprime-related allegations. Judge Davis’s ruling is noteworthy in that regard for its rejection of the defendants’ "fraud by hindsight" arguments.

Judge Davis’s opinion is perhaps most noteworthy in its acceptance of the "core business operations" theory in concluding that the plaintiffs had adequately pled scienter. Though earlier courts had rejected this theory as inconsistent with the PSLRA’s pleading requirements, more recently courts, for example, in the Ninth Circuit (refer here) and the Seventh Circuit (refer here), have taken it up. As noted in a recent commentary by the Katten Muchin law firm entitled "Reform Act Under Attack?" (here), the core operations theory "has made a comeback in 2008," which the authors contend is inconsistent with the PSLRA’s meaning and intent.

Were other courts similarly willing to take up the core operations doctrine, it could substantially impact the many pending dismissal motions in various subprime-related securities lawsuits.

In any event, I have added the RAIT opinion to my table of subprime and credit crisis-related securities lawsuit settlements, dismissals, and dismissal denials, which can be accessed here.

Special thanks to a loyal reader for alerting me to the RAIT opinion.

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When the various broker dealers and investment banks recently announced their agreements with government regulators to buy back auction rate securities, the announcements raised questions about the continuing need for the pending auction rate securities litigation. But, at least based on a recently filed lawsuit, it now appears that the settlements may have opened the door for a whole new round of securities litigation related to the settlements themselves.

On October 3, 2008, plaintiffs’ lawyers initiated a securities class action lawsuit in New York (New York County) Supreme Court on behalf of investors who purchased bonds and preferred securities in various offerings conducted pursuant to Merrill Lynch’s March 31, 2006 shelf registration. A copy of the complaint can be found here. The complaint, which asserts claims under Sections 11, 12 and 15 of the ’33 Act, names as defendants Merrill Lynch and related entities; certain current and former Merrill Lynch directors and officers; the underwriters that conducted the various offerings; and Merrill Lynch’s auditor.

The complaint alleges that the offering documents "misstated Merrill’s financial condition and failed to disclose that the Company bore massive exposure to losses from investments tied to subprime and other mortgages, and was responsible for significant liability arising from its participation in the market for auction rate securities (ARS). Further Merrill improperly valued mortgage-backed assets on its books, and failed to account for its contingent obligations in the ARS market."

The complaint alleges that as a result of later disclosures about the company’s "true financial condition," the value of the securities sold in the referenced offerings declined materially. The complaint specifically refers to, regarding the company’s true financial condition, Merrill Lynch’s August 7, 2008 announcement (here) that "it would repurchase $12 billion in ARS from investors due to the failure of the ARS market."

Merrill Lynch previously was the target of what I will call a "conventional" auction rate securities lawsuit. Background regarding this prior lawsuit can be found here and regarding the prior auction rate securities lawsuits generally can be found here.

This new Merrill Lynch lawsuit complaint differs from the prior conventional auction rate securities lawsuit in a variety of ways. The most important distinction is who is represented in the plaintiff class. The prior auction rate securities lawsuits were brought on behalf of auction rate securities investors – that is, the people who bought the actual auction rate securities. The plaintiffs in the Merrill Lynch lawsuit are not persons who bought auction rate securities, but who bought Merrill Lynch’s own securities in the referenced offerings.

The misrepresentations alleged are different as well. In the conventional auction rate securities lawsuits, the allegation is that the risks of the auction rate securities were insufficiently disclosed. In this new lawsuit, the allegation is not about the risks of auction rate securities themselves, but rather that Merrill Lynch did not disclose its own susceptibility to contingent liability in connection with its issuance or sale of the auction rate securities.

One other peculiarity of the prior auction rate securities lawsuits is that those suits generally did not name any individual defendants. The new Merrill Lynch complaint names a couple of dozen individual defendants, as well as several dozen offering underwriters.

Given the number and identities of the various defendants, this lawsuit will keep a lot of lawyers employed for a long time. Among the preliminary issues on which the lawyers will be engaged is the court’s subject matter jurisdiction. The plaintiffs elected to file their lawsuit in state court pursuant to the concurrent jurisdiction provisions in Section 22 of the ’33 Act. The defendants undoubtedly will seek to remove the lawsuit to federal court, and the plaintiffs in turn will seek to have the case remanded to state court.

As I noted in a prior post (here), the Ninth Circuit recently upheld the decision of the district court in the Luther v. Countrywide case to remand a ’33 Act case back to state court, where it originally had been filed before being removed to federal court. However, as the 10b-5 Daily blog recently noted (here), a judge in the Southern District of New York refused to remand New Jersey Carpenters Vacation Fund v. Harborview Mortgage Loan Trust, which had been removed to federal court. Among other things the court in the Harborview case held that the provisions of the Class Action Fairness Act trumped the jurisdictional provisions of the ’33 Act.

In view of the fact that the new Merrill Lynch case likely will be remanded to the Southern District of New York (the same court in which the Harborview case is pending), it will be interesting to see whether the plaintiffs are able to have the case remanded back to the New York state court where they initially filed the new Merrill Lynch complaint.

As I have previously noted, along with the question whether or not a ’33 Act case properly can be removed to federal court is the more practical question of why the plaintiffs want to proceed in state court in the first place. Some day someone will explain to me why the plaintiffs’ bar suddenly has developed this fascination with pursuing ’33 Act claims in state court. Is it, as I have supposed, an effort to circumvent the procedural requirements of the PSLRA?

In any event, I have added the new Merrill Lynch complaint to my running tally of subprime and credit crisis-related securities lawsuits, which can be accessed here. With the addition of the new lawsuit, the current tally now stands at 125, of which 85 have been filed in 2008. Of these, 21, including the new Merrill Lynch lawsuit, are auction rate securities lawsuits.

Motion to Dismiss Granted in Subprime Securities Lawsuit: On September 29, 2008, Judge John Steele of the Middle District of Florida granted the defendants’ motion to dismiss, without prejudice, in one of the more unusual subprime related securities lawsuits. A copy of the opinion can be found here.

As detailed here, the plaintiffs allege that the defendants (First Home Builders of Florida and two residential real estate brokerage firms, as well as successor entities), in violation of the federal securities laws, had fraudulently induced plaintiffs to purchase real estate investment properties by promising that defendants would procure lease-to-own tenants for the investors’ properties; that the tenants rental payments would cover all of the investors’ out-of-pocket costs; and that investors would receive a guaranteed 14% return on the investment in the first year.

Judge Steele granted the defendants’ motion to dismiss, ruling that as a result of the plaintiffs’ failure "to allege who made what misrepresentations," the plaintiffs’ fraud allegations failed to meet the pleading requirements of Rule 9(b). Judge Steele declined to rule on the plaintiffs’ group pleading theory. He allowed plaintiffs 30 days to file an amended complaint.

I have added the First Home Builders of Florida dismissal to my table of subprime and credit crisis-related lawsuit case dispositions, which can be accessed here.

Special thanks to Adam Savett of the Securities Litigation Watch blog (here) both for the Merrill Lynch complaint and for the opinion in the First Home Builders of Florida case.

Note from Ohio: I want to know how the Saturday Night Live scriptwriters managed to get the whole  "Joe the Plumber" schtick inserted into tonight's actual Presidential debate. But the one thing I do know is that after tonight's debate, my fellow Ohioan, Joe the Plumber, is moving to Canada, where he will be left in peace because their national election is already finished.

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We are now well into the second year of the current subprime litigation wave, but the rulings on preliminary dismissal motions are still just trickling in. In the latest of the early returns, involving one of the earliest subprime securities lawsuits, Judge James T. Giles of the Eastern District of Pennsylvania in an opinion dated August 29, 2008 denied defendants’ motion to dismiss the securities lawsuit pending against home builder Toll Brothers and nine of its directors and officers.

A copy of the August 29 opinion can be found here. Background regarding the case can be found here.

According to the Amended Complaint (here), between December 9, 2004 and November 8, 2005, the defendants made several misrepresentations relating to the company’s "ability to open new active selling communities at the rate necessary to support its financial projections, traffic in its existing communities, demand for Toll Brothers homes, and the ability to continue its historically strong earnings growth." The Amended Complaint further alleges that despite "adverse developments" the company raised its earning projections, which allegedly inflated the company’s share price, facilitating the defendants’ sale of 14 million of company shares for proceeds of over $617 million.

The Amended Complaint also alleges that "within days" of the completion of the insider sales, defendants "shocked investors" in a series of disclosures between August and November 2005 revealing that traffic and sales were declining, as a result of which the company’s share price declined 43% from its class period high.

Judge Giles’s August 29 opinion is relatively brief and largely represents a statement of his conclusions rather than an explanation of his reasoning. Thus, he simply states that plaintiffs have adequately alleged material misrepresentations and omissions, and have adequately alleged that defendants’ forward-looking misrepresentations were "knowingly unreasonable" at the time made. He also states that plaintiffs have adequately alleged that the company’s forward-looking statements were not accompanied by sufficient cautionary language and were mixed with representations of current condition.

The Judge’s rulings with respect to the issues of scienter and loss causation are slightly more detailed and are also more interesting.

With respect to the issue of scienter, Judge Giles noted that "Plaintiffs have alleged that Defendants’ stock sales were unusual in scope and timing, and the court finds these insider allegations are pled with the particularity required by the PSLRA." As a purported "plausible opposing inference," the defendants contended that the purpose of their stock sales "was diversification of their investments." The court concluded that "a reasonable person would find that the inference of scienter is at least as strong as the opposing inference."

With respect to the issue of loss causation, the plaintiffs alleged that the defendants made four statements between August and November 2005 that revealed the truth about the company. The defendants contended that plaintiffs "inappropriately grouped" the alleged "revelations" together in an attempt to establish loss causation.

Judge Giles rejected the defendants’ argument, and found that the plaintiffs made two allegations with respect to loss causation that the court found to be sufficient: first, the plaintiffs alleged that each of the four revelations and subsequent stock price drops were actionable; and second the plaintiffs allege that "through these four revelations" defendants "gradually revealed the truth regarding their prior misrepresentations."

Because the bases of Judge Giles’s rulings are not detailed, his opinion is unlikely to be influential in other subprime-related securities cases, particularly since the magnitude and timing of the alleged insider trading clearly seems to have been an important factor. Judge Giles’s willingness to accept the plaintiffs’ allegations that the truth was "gradually" revealed as sufficient to satisfy loss causation pleading requirements could be more significant, as plaintiffs in cases in which there was no abrupt stock price drop often attempt to make similar "gradual revelation" arguments.

In any event, Judge Giles’s ruling joins the small collection of subprime-related securities lawsuit dismissal motion determinations, a list of which may be accessed here. Although among the small group of rulings dismissal motions have been both granted and denied, the motion denial in the Toll Brothers case comes after the two most recent rulings in the Standard Pacific (refer here) and NovaStar (refer here) cases, in which the dismissal motions were granted.

There are many more cases in which the dismissal motions are yet to be heard, but Judge Giles's opinion in the Toll Brothers case is a reminder that even with the substantial arguments that defendants can make in reliance on Tellabs and Dura Pharmaceuticals, some cases will nevertheless survive motions to dismiss. At least based on the Toll Brothers ruling, the presence of significant insider sales may be a significant factor in producing that result.

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The subprime and credit crisis-related litigation wave has come a long way since the first of the subprime lawsuits was filed in February 2007. Now that the litigation phenomenon is now nearly a year and a half old, the rulings on the motions to dismiss are finally starting to accumulate. It appears to be time for The D&O Diary to initiate the latest in its ongoing and ever-popular series of lists, this most recently created one to track the accumulated subprime and credit-crisis related lawsuit dismissals and dismissal motion denials.

The D&O Diary’s newly created list of subprime and credit crisis-related dismissals and motion denials can be found here. PLEASE NOTE that this document also lists all settlements of subprime and credit crisis related lawsuits as well

As befits the relatively early stages of most of this litigation, the list of case dispositions is, as of the time of the list’s initial creation, pretty sparse. I will endeavor to update the list as new dismissal motion rulings emerge, and wherever possible I will provide a link to the actual ruling. As I update the list, I will indicate at the top of the list the date of the list’s most recent revision.

The more complete the list is, the more useful it will be for everyone, so all readers are strongly invited and encouraged to let me know about any subprime and credit crisis related lawsuit dismissal motion rulings that are not already on the list.

As of the date of the creation of this post, I am not aware of any subprime or credit-crisis related lawsuit settlements. The settlements will emerge sooner or later, and when the do, I will created a supplemental document tracking the settlements.

Readers who may be unaware of the other lists that I am maintaining may be interested to know about the following lists:

1. The List of Subprime and Credit Crisis-Related Securities Class Action Lawsuit Filings (which may be accessed here).
2. The List of Subprime and Credit Crisis-Related Derivative Lawsuits (here).
3. The List of Options Backdating-Related Lawsuit Filings (here)
4. The List of Options Backdating-Related Dismissals, Denials and Settlements (here).
5. The List of Securities Class Action Opt-Out Settlements (here).

I am always interested in any additional information or correcting information that is required to make these lists more accurate or complete. I am also always interested in readers’ thoughts and comments, about these lists or anything else.

Welcome Back: Serial blogger Bruce Carton is back at it again, with his new blog, Unusual Activity, which can be found here. The blog describes itself as "The Securities Litigation and Enforcement Reporter."  Many readers will recall that Bruce is the founder and long-time author of the Securities Litigation Watch blog. Bruce more recently wrote the Best in Class blog. Everyone here welcomes Bruce back to the blogging circuit, and we look forward to reading his new blog.

Speakers's Corner: On June 19 and 20, 2008, I will be co-Chairing the Mealey's Subprime Mortgage & Insurance Coverage Litigation Conference at the Ritz-Carlton in Pentagon CIty, Virginia, with my good friend, Matt Jacobs, of Jenner & Block.

The agenda (which can be found here), includes many distinguished speakers and panelists, such as Andrew Carron of NERA Economic Consulting, Adel Turki of Cornerstone Research, Robert Rothman of the Lerach Coughlin firm, Dan Bailey of Bailey & Cavalieri, John McCarrick of Edwards Angell Palmer & Dodge, David Hensler of Hogan & Hartson, and Mitchell Dolin of Covington & Burling.

Registration instructions and other intormation about the conference can be found here.

And Finally: If you have never heard of the Social Science Research Network (SSRN), then you will want to review the article yesterday's New York TImes (here) discussing the latest in academic anxieties. It used to be all publish or perish, but it is now all about the downloads and links. And you thought your job was competitive.

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In arguably the most substantive ruling yet in a subprime-related securities class action lawsuit, Judge Ortrie Smith of the United States District Court for the Western District of Missouri, in a June 4 opinion (here) in the NovaStar Financial subprime-related securities class action lawsuit, granted the defendants’ motion to dismiss with prejudice.

The NovaStar lawsuit, which was first filed on February 23, 2007, was one of the first subprime-related securities class action lawsuits to be filed. Background regarding the lawsuit can be found here. The lawsuit alleges that NovaStar, a real estate investment trust, lacked adequate internal controls, as a result of which the company materially misstated its financial results and condition. The lawsuit followed the company’s February 20, 2007 announcement of disappointing results and deteriorating marketplace conditions.

Judge Smith granted the motion to dismiss on the grounds that the complaint does not adequately plead falsity and does not adequately plead scienter.

In addressing the falsity requirements, Judge Smith noted the PSLRA’s specificity requirements, and observed that the complaint, despite its over 100 pages and over 200 paragraphs “presents a very broad picture, and Plaintiff discusses his claims in generalities – precisely what the PSLRA counsels against.” This, Judge Smith said, allowed the Complaint to “create the illusion of detail and insinuate the existence of fraud, which in turn has made it exceedingly difficult for the Court to conduct the analysis required by law.”

After reviewing the complaint’s specific allegations of falsity and finding them each in turn to be inadequate, Judge Smith concluded that “ultimately, Plaintiff fails to identify a single false entry in the Company’s financial statements, nor does he identify the ‘truth’ that should have been disclosed.” Judge Smith goes on to add that the Complaint “reads more like a cautionary tale from a treatise on business management than a charge of knowing misstatements and concealments.” Companies, the court said, “are not expected to be clairvoyant and bad decisions do not constitute fraud.”

With respect to plaintiff’s scienter allegations, the court concludes that the plaintiff “had not presented facts creating an inference of scienter that is at least as strong as an inference that Defendants lacked fraudulent intent.” The court noted that the allegations are “more consistent with a company and executives confronting a deterioration in the business and finding itself unable to prevent it than they are with a company and executives recklessly deceiving the investing community.”

Judge Smith declined to allow the plaintiffs leave to replead, concluding it “would be futile,” since there is “no suggestion that any material was concealed or that any Defendant acted with fraudulent intent, and there is no reason to think further or different pleading will created the necessary inferences.”

The Court’s opinion is pretty much a clean sweep for the defendants, but it is hard to know what the larger significance of the opinion might be. There are few other subprime cases pending in the Western District of Missouri (for which the plaintiffs’ bar is undoubtedly grateful, given the outcome in the NovaStar case), and courts in other jurisdictions may or may attach weight to Judge Smith’s ruling.

One aspect of the opinion that could be significant if it represents the perspective with which other courts will view these cases, and that is the extent to which Judge Smith viewed this case through the screen of the generally deteriorating financial markets and business conditions. Other judges, like Judge Smith, may be similarly disinclined to find anything nefarious in a company’s failure to anticipate declining business conditions – at least in the absence of insider trading or other more compelling factors.

While there may be cases such as the Countrywide derivative lawsuit which courts may be predisposed to allow (about which refer here), there may be others, like the NovaStar case, where courts prove unwilling to infer wrongdoing from business reverses. At a minimum, the NovaStar opinion is a reminder that merely because a company’s fortunes have declined and the plaintiffs have filed a lawsuit does not necessarily mean that the plaintiffs will prevail or make any recovery. There may be more than a few of the cases filed as part of the subprime litigation wave that also fail to survive the initial pleading hurdles.

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In my preceding post, I quoted recent reassuring words from Treasury Secretary Henry Paulson about the current credit crunch. Billionaires Warren Buffett and George Soros apparently have a less sanguine view, and there is in any event substantial recent evidence to support the view that, whether or not the worst is over, the effects will be felt for some time to come.

According to news reports (here), Warren Buffett told reporters in Europe yesterday that “I don’t necessarily think we’re halfway through or necessarily a quarter of the way through the effects throughout the general economy. The initial effects are felt by people who really did the silliest things, but you can have a whole bunch of domino-type effects that eventually can get to people who are doing fairly sound things.” Buffett added that “I think there will be rippling secondary, tertiary effects.”

Soros, while willing to concede (here) that the “acute phase” of the crisis may have passed, also said that “now we have to feel the effects,” which he said might “almost inevitably” include recessions in the U.S. and U.K.

An even more pessimistic voice is that of Meredith Whitney, the analyst for Oppenheimer who correctly predicted disaster for Citigroup and others last fall. She recently said (here) that "the credit crisis is far from over" and "what lies ahead will be worse that what is behind us." Dang.

There are already a wide variety of effects that are rippling through the economy and affecting a diverse array of companies, even outside the financial sector. For example, on May 19, 2008 Bloomberg reported (here) that “more than 300 companies are struggling to value auction rate bonds” that they are carrying on their balance sheets. These companies’ auction rate securities investments were valued at $98 billion as recently as January 1, 2008.

“About half” of these companies have “reported losses totaling $1.8 billion as the markets for securities, sold as higher-yielding alternatives to money markets, seized up.” Among the companies the Bloomberg article names as having taken auction-rate securities-related write-downs are UPS, Google, HCA and Teva Pharmaceuticals. But while half of the companies holding these assets may have recognized the valuations issues, the other half have not, and even the companies that have taken some recognition have the issue of whether or not they got it right.

The wide dispersion of these and other credit crunch-related exposures throughout the economy puts pressure on many companies to recognize the risk; companies that delay or avoid recognition may be laying in problems down the road. As one commentator said in another Bloomberg article (here), “the smart people are the ones who’ve identified the problems, put them out there in full transparency, and addressed them by raising more capital. There is still billions of dollars of crap out there that hasn’t worked its way through the system.”

The May 19, 2008 Bloomberg article in which this latter statement appeared is entitled “Banks Keep $35 billion Markdowns Off Income Statements” (here). The article describes multiple financial institutions that are “failing to acknowledge their in their income statements at least $35 billion of additional write-downs included in their balance sheets.” A commentator in the article notes that “keeping the markdowns off income statements just delays the realization of losses.” Indeed, the article suggests that ignored bad debt and postponing the inevitable losses is one of the reasons behind Japan’s decades long economic slump.

Behind every postponed day of reckoning is an optimistic hope that the reckoning might not just be delayed but perhaps avoided altogether. And perhaps things will come right. But the kinetic potential for the kinds of secondary and tertiary ripple effects Buffett projected inheres within every one of these postponements, laying the potential for further disruption when the day of reckoning arrives.

The consequences of these secondary and tertiary effects inevitably will include litigation, as is perhaps illustrated by the lawsuit, described in today’s Wall Street Journal (here), in which Fifth Third Bank has sued an insurer and a brokerage firm that arranged an investment for the bank in the Citigroup Falcon Strategies hedge fund. (A copy of the complaint can be found here.)

Fifth Third’s investment involved a complex life insurance investment, in which the aggregate premiums were invested in a diversity of assets. The complaint alleges that the defendants failed to monitor and manage Fifth Third’s $612 million investment, particularly when changing conditions (triggered by the credit crunch) should have triggered a reallocation of assets. This lawsuit demonstrates the range of potential litigation issues and the breadth of potential litigation targets that may become involved in future litigation. 

In a post on this blog last December (here), I discussed “the truth telling yet to come” in connection with the subprime meltdown. In many ways, the phrase is even more apt now. The dynamic possibilities of the truth telling yet to come include the litigation yet to come, as well. And as Buffett said, we are not necessarily even a quarter of the way through this yet.

A June 1, 2008 article in Corporate Counsel entitled “Wipeout!” (here) describes the credit crisis-related litigation to date and the litigation yet to come. Among other things, the article quotes one commentator as saying that “we haven’t seen most of the litigation yet.”

Top Ten Securities and Corporate Law Review Articles: The Securities Litigation Watch blog (here) has reproduced (with hyperlinks) the list of the Top Ten Corporate and Securities Law Review articles of the year. I was very pleased to see that my good friends Tom Baker and Sean Griffith's article "The Missing Monitor in Corporate Governance: The Directors' & Officers' Liabiltiy Insurer" (here) made the list. I discussed Professor Baker and Griffith's article at length in an earlier post, here.

A Big Fee Anwhere (But Especially in Tajikistan): A May 20, 2008 Financial Times article about lawyers’ fees entitled “Time to Stop the Lawyers’ Clock from Ticking” (here), noted that observers had

expressed concern about the £50m in fees that Herbert Smith, another top firm, expects to bill on behalf of Tajikistan in a dispute over alleged corruption at a state-owned aluminum smelter.

The projected costs, revealed at a High Court hearing in April, would represent 2.7 per cent of the central Asian nation’s gross domestic product, where the average monthly wage stands at a paltry $63.

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In the most in-depth review yet of a subprime-related lawsuit complaint, Judge Mariana Pfaelzer of the Federal District Court in Los Angeles, in an order dated May 14, 2008 (here), denied the defendants’ motions to dismiss the amended complaint in the consolidated derivative lawsuit filed against Countrywide Financial, as nominal defendant, and against eleven individual current and former officers and directors.

The derivative complaint (a copy of which can be found here) accuses the defendants of misconduct and of disregard of their fiduciary duties, and alleged lack of good faith and lack of oversight of Countrywide’s lending practices, financial reporting and internal controls. The amended complaint also contains insider trading allegations, based on the individual defendants’ sale of over $848 million of their holdings in Countrywide stock while in the possession of material inside information, between 2004 and 2008.

The defendants moved to dismiss the plaintiffs’ derivative claims on the ground that the plaintiffs had not make pre-suit demand or adequately pled that demand was excused.

Judge Pfaelzer began her analysis with some harsh words for the plaintiffs’ complaint, which she described as “prolix and sprawling.” Notwithstanding these concerns, she proceeded to the merits in a ruling that largely went the plaintiffs’ way.

She opened her analysis with the observation that standards to determine whether demand is excused “overlap considerably” with the standard for establishing a claim under Section 10(b) of the ’34 Act. She said that the two issues are “inextricably intertwined,” and proceed to determine that in several material respects the plaintiffs’ allegations satisfy the pleading requirements under the standards of the recent Tellabs case.

Judge Pfaelzer found that the plaintiffs’ allegations create a “cogent and compelling inference that the individual Defendants misled the public with regard to the rigor of Countrywide’s loan origination process, the quality of its loans, and the Company’s financial situation – even as they realized that Countrywide had virtually abandoned its own loan underwriting processes.”

In support of these allegations, the plaintiffs relied on confidential witnesses, whom the court said “paint a compelling picture of a dramatic loosening of underwriting standards in Countrywide branch offices across the United States.” The court said that “plaintiffs’ numerous confidential witnesses support a strong inference of a Company-wide culture that at every level emphasized increased loan origination volume in derogation of underwriting standards.”

The court found further that the plaintiffs' allegations support the contention that many of the individual defendants were aware of the deterioration of standards. After reviewing the “red flags” that should have alerted the individual members of various board committees, the court found that the plaintiffs’ allegations raise “a cogent and compelling inference that the Audit & Ethics committee members were aware of (or proceeded with deliberate recklessness with respect to) the significance of red flags related to increasing delinquencies, negative amortizations, and other signs of loan nonperformance.”

Similarly, the court also found that the allegations “give rise to a compelling inference” that Credit Committee members were made aware of signs of deterioration. The court also found that members of the Finance Committee “either knew or proceeded with deliberate recklessness with respect to, the fact that loans to borrowers who could not pay back their mortgages would ultimately be counterproductive, lucrative as it was in the short run.”

The court also found that plaintiffs had asserted facts to support a strong inference that members of the Operations & Public Policy Committee had acted with scienter. However the court found that “without more, the court does not fund membership on the Compensation Committee probative of scienter.”

In concluding that the allegations taken as a whole support an inference of scienter, the court stated that

independent of any turmoil in the capital markets, the widespread violations of underwriting standards would significantly raise risk of loan defaults. When combined with what the Plaintiffs allege are misrepresentations concerning the quality of Countrwide’s loans, the underwriting issues would ultimately undermine confidence in the secondary market for Countrywide products.

In further support of the scienter findings, the court referred to the company’s aggressive stock repurchase program, undertaken and continued at a time when the company’s share price escalated and while insiders were dumping their own shares. While the defendants offered competing innocent explanations for the insider sales, the court found that the plaintiffs’ “repurchase-related insider trading allegations … are at least consistent with their theory of fraud” and “provide some support” against the motion to dismiss. The repurchase program could be viewed as “an attempt to keep the ball rolling” by steadying the company’s share price “before the weight of the loan origination practices began taking their toll on the company’s operations and the value of its stock.”

The plaintiffs also relied on Countrywide CEO Angelo Mozillo’s alleged manipulation of his Rule 10b5-1 trading plan, about which the court said that “Mozillo’s actions appear to defeat the very purpose of Rule 10b5-1 plans.” The court rejected the innocent explanations offered for the changes to Mozillo’s plan, saying that the factors “do not mitigate against the inference of scienter given the magnitude and timing of Mozillo’s trading,” which amounted to hundreds of millions of dollars in stock trading proceeds.

After this detailed review of the scienter requirements and allegations, the court quickly worked through the other pleading requirments and proceeded to the ultimate question whether the plaintiffs’ allegations satisfied the demand futility standards. In considering this issue, the court again reviewed the allegations that the various board committee members were aware of the deteriorating loan practices yet failed to take corrective actions.

Since the same individuals who would have had to have considered the litigation demand were involved in these alleged circumstances, the court found that “a majority of the directors are ‘interested’” and therefore demand is excused (except as pertains to a category of claims relating to Mozillo’s compensation). The court also dismissed out two individual defendants based on the specific allegations relating to their individual involvement. The court directed the plaintiffs to file an amended complaint consistent with the order within 20 days.

At one level, Judge Pfaelzer’s order is a reflection of the specific allegations in the Countrywide complaint, particularly as pertains to the allegations of deteriorating underwriting and loan origination practices, and as pertains to the Mozillo’s insider trading. The outcome was also influenced by the allegations based on the factual observations of numerous confidential witnesses. To that extent, Judge Pfaelzer’s order may simply be a reflection of the alleged circumstances of the specific case and have relatively little potential significance for other pending subprime-related cases.

However, there may yet be a sense in which this order is relevant for other cases, and that is the court’s clear discomfort for the allegedly deteriorating practices in contrast to the company’s statements and the insiders’ stock sales. Other pending cases contain allegations pertaining to the excesses of the subprime lending marketplace, and other cases also contain allegations of insiders profiting while underwriting and loan origination practices deteriorated.

While there is at least this potential relevance of the Countrywide case for other subprime-related litigation, the larger significance is simply its primacy. Because it is one of the first cases with a detailed review of the allegations, the courts’ apparent receptivity to the plaintiffs’ allegations may be significant. Other defendants in other cases may be able to establish the insufficiency of the plaintiffs’ allegations, but the Countrywide decision could be interpreted to suggest that the defendants will have to overcome courts’ receptivity to similar allegations.

Judge Pfaelzer’s analysis of the allegations concerning Mozillo’s Rule 10b5-1 plan are also interesting, because they underscore the extent to which courts will be wary of apparent attempts to use plans to shield improper trading. When the dust settles on this case, there likely will be a fruitful opportunity to consider the lessons from these circumstances for proper and improper uses and structures of Rule 10b5-1 plans.

The WSJ.com Law Blog has a interesting post here discussing the background and context of Judge Pfaelzer’s opinion.

Special thanks to a loyal reader who prefers anonymity for providing a copy of the order.

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As the markets for various types of subprime-related assets have seized up, many companies find themselves faced with complicated issues concerning asset valuation and disclosure. These issues have in turn both subjected companies to the possibility of litigation and encouraged investors to target the entities and institutions that sold them the assets in the first place. The extent of the asset valuation and disclosure issues suggests that the turmoil, and the ensuing litigation, will continue to spread.

One example where the valuation and disclosure issues have already led to litigation involves the securities class action lawsuit filed in the United States District Court for the District of Minnesota on March 28, 2008 against MoneyGram International and certain of its directors and officers. A copy of the plaintiffs’ attorneys’ press release can be found here and a copy of the complaint can be found here.

The complaint against Moneygram relates to the company’s January 14, 2008 press release (here) in which the company stated that it had completed its valuation of its investment portfolio as of November 30, 2007, as a result of which the company said that it had “experienced net unrealized losses of $571 million from September 30, 2007, bringing cumulative net unrealized losses to $860 million.” The company also announced that it has commenced a process to “realign is portfolio away from asset-backed securities,” as a result of which it had realized in January a loss of $200 million on asset sales of $1.3 billion.

According to the plaintiffs’ lawyers’ press release, the complaint alleges that the defendants “concealed from the investing public” that:

(a) the Company lacked requisite internal controls to ensure that the reserves for the Company’s investments in asset-backed securities were adequate, and, as a result, the Company’s projections and reported results issued during the Class Period were based upon defective assumptions and/or manipulated facts; and (b) the Company concealed the extent of its potential losses arising from its exposure to asset-backed securities containing uncollectible debt.

The prospect of securities litigation arising from asset valuation and disclosure issues is a potentially very substantial problem, because so many companies are facing these same kinds of issues due to asset-backed securities in their investment portfolio. Similarly, companies holding auction rate securities are facing particularly challenging valuation and disclosure issues, and as I have previously noted (most recently here), these challenges are not limited to companies in the financial sector, but indeed are widely dispersed throughout the economy. For example, a March 28, 2008 Wall Street Journal article entitled “’Auction Rates’ Clip Tech Firms’ Profits” (here) discusses the financial impacts that a variety of technology companies are facing because of the companies’ inability to convert their auction rate securities holdings into cash.

One measure of the depth of the problems arising from the failure of the auction rate securities market is that it is not just companies whose balance sheets are under pressure. Many households and individuals are also now about to recognize their own personal balance sheet hits due to the auction rate problem. According to a March 29, 2008 Wall Street Journal article entitled “UBS Plans Auction-Rate Price Cut” (here), UBS is going to lower the values of the auction rate securities held by its customers. The reduced values, which will be based on computer models and “will range from a few percentage points to more than 20%” will be reflected on their customers’ forthcoming statements.

As I have previously noted (most recently here), investors have already filed a number of class action lawsuits against the companies that sold them auction rate securities, and on March 27, 2007, Citibank became the latest to be sued in a securities class action on behalf of investors for its sale of auction rate securities (see press release here and complaint here). The reduction of the carrying values of auction rate securities on investors’ statements will likely further bestir investors and could lead to even more litigation. But making no adjustments could create a different set of issues and lead to greater problems later.

The question of how best to reflect the valuation of assets for which there is no current market is one that potentially affect participants at all levels of the economy. And while there undoubtedly will be more lawsuits on behalf of investors against the companies that sold them the auction rate securities, a potentially greater litigation threat may arise from shareholders who may contend they were misled about a company’s balance sheet exposure to these kinds of assets. There could well be a great deal of litigation in which it is alleged, as asserted in the complaint in the MoneyGram case, that a company failed to disclose the “extent of its potential losses arising from its exposure to asset-backed securities containing uncollectible debt.”

The extent of the problem shall be revealed in the fullness of time. But meanwhile the subprime-related securities class action litigation still continues to accumulate. With the addition of the MoneyGram and Citigroup lawsuits, my running tally of subprime-related securities lawsuits (which can be accessed here) now stands at 61, 23 of which have been filed in 2008, and seven of which are filed on behalf of auction rate investors against the companies who sold them the securities.

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Synthetic CDOs-squared offer investors higher spreads than single-layer CDOs but also may present additional risks. These two-layer structures somewhat increase exposures to certain risks by creating performance "cliffs." That is, seemingly small changes in the performance of underlying reference credits can cause larger changes in the performance of a CDO-squared.

Of particular interest to bond insurers (and investors in a bond insurer that happens to insure CDOs squared) is that CDOs squared "display particular sensitivity" to "frequency of defaults." Based on a very detailed analysis, the Nomura article concludes that "higher default rates affect a CDO-squared tranche much more dramatically than the underlying CDO tranche." The report goes on to state, among other things that, that "for example, the probability of a [CDO squared] tranche wipeout goes from 0.6% to 41.2% as the [CDO tranche] default rate goes from 1.0% to 1.5%."

Snakes and Ladders: The Nomura article's discussion of the risks involved with CDOs squared brings to mind Warren Buffett's frequent diatribes against derivative securities. For example, in his letter to shareholders in the 2002 Berkshire Hathaway Annual Report (here), Buffett referred to derivatives as "time bombs" and as "financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal." (Full disclosure: I own Class B Berkshire shares, although not nearly as many as I wish I did.)

I have struggled over the years to understand the vehemence of Buffett's condemnation of derivatives, but I gained fresh insight recently when I read Roger Lowenstein's excellent book When Genius Failed, which recounts the formation, growth and dramatic collapse of Long-Term Capital Management. The events described in the book took place a decade ago, but many of the same events, circumstances, complications, and even many of the same people, were involved then as are involved in the current subprime meltdown.

LTCM's story is far more complicated than can easily be recounted here, but the most critical facts are that at the beginning of 1998, the firm had equity of $4.72 billion, but as a result of leverage, carried balance sheet assets of around $129 billion. Even more astonishing were the firm's off-balance sheet derivative positions, which had a notional value of $1.25 trillion. Adverse global financial circumstances in August and September 1998 put LTCM on the wrong side of a huge number of arbitrage bets, and put the firm in a position where it had to liquidate positions, only to find that there were no willing buyers. Lack of liquidity and the firm's highly leveraged position not only threatened the firm with failure, but, owing to LTCM's massive indebtedness, threatened a constellation of financial institutions with enormous losses. The Federal Reserve became concerned that the ensuing fallout could cause panic and damage the financial markets.

The scramble to protect the financial markets from an LTCM meltdown involved a veritable who's who of the financial world, including the redoubtable Mr. Buffett. Reading about Buffett's role in the LTCM crisis gave me some insight into his loathing of derivative securities.

First, the book makes it clear that in connection with Berkshire's then-pending acquisition of General Reinsurance Corporation (which ultimately closed in December 1998), Buffett was worried about Gen Re's involvement in certain LTCM investments on which Gen Re had counterparty exposure or for which Gen Re had provided financing. (Full disclosure: At the time, I was an employee of a Gen Re operating subsidiary.)

In addition, Buffett was also deeply involved in a Goldman Sachs-led proposed buyout of LTCM, that would have given the acquirers control of LTCM's assets for $250 million, a small fraction of the assets' putative (and as events turned out, ultimate) value. The potential buyout did not come off, in part because of Buffett's inaccessibility at critical moments while he was vacationing in the Pacific Northwest with Bill Gates.

As a result of these events, Buffett apparently had a window into LTCM's portfolio and apparently came away with an unfavorable view of derivative securities. Indeed, Buffett specifically references LTCM's near meltdown and disparages some of LTCM's derivative investments ( particularly "total return swaps") in the 2002 Berkshire shareholders letter linked above.

As an aside, it is worth noting that Buffett is only one of a host of people now prominent in the subprime crisis who played one role or another in the LTCM bailout. For example, John Thain, recently given the assignment of turning around Merrill Lynch, was deeply involved in the LTCM bailout efforts as CFO of Goldman Sachs. Jon Corzine, now the democratic governor of New Jersey, was also involved in many of the discussions. James Cayne, who just this past week resigned as head of Bear Stearns as a result of that company's subprime woes, played a significant although not particularly constructive role in the LTCM bailout as well.

Although Lowenstein's book refers to events from ten years ago, it rewards reading now, because it shows how some of the same recurring behaviors drive occasional excesses and trigger periodic crises in the financial markets. Indeed, the recurrence of many of the same circumstances and names today gives the impression that the global financial marketplace represents nothing more than an elaborate game of Snakes and Ladders, where the same money, investments and people slide around in certain prescribed paths and wind up ahead or behind as the game unfolds.

There is also a certain symmetry between the events surrounding LTCM's near-demise and the current subprime crisis; once again, for example, Buffett is cast in the role of potential rescuer, in particular now with respect to bond insurers (about which refer here). But the more important connection between the two sets of circumstances is the role of complicated derivative securities in contributing to the respective crises. Indeed, given the role that these immensely complicated derivative securities, such as CDOs squared , are playing in the current subprime crisis, Buffett's comments in the 2002 shareholders letter about the dangers of derivative securities may be required reading for anyone who wants to understand what is going on today.

 

A Reflection on Winter in the Suburbs: Am I the only one who thinks the very idea of "decorative cabbages" is ridiculous?

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