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

 

The credit-crisis securities litigation wave, which began with the filing of the first subprime mortgage-related lawsuits in early February 2007, is about to enter its third year. Though the wave has evolved during the intervening period, it shows no sign of slowing down. The more interesting question going forward will be whether the litigation, which up until now has largely been concentrated in the financial sector, will spread to encompass companies in the wider economy.

The Wave’s History – So Far

The current subprime and credit crisis-related securities litigation wave began on February 8, 2007, with the filing of a securities lawsuit against New Century Financial Corporation and certain of its directors and officers. (Refer here for my most recent post on the New Century case.) Two years later, there have been 152 separate subprime or credit crisis-related lawsuits filed against companies and other entities, as reflected in my running tally of the suit, which can be accessed here.

The initial cases during 2007 were largely filed against subprime loan originators, banks, mortgages companies, home builders and residential real estate investment trusts. However, by year end 2007, a number of lawsuits had also been filed against investment banks, investment advisors, and rating agencies.

During 2007, there were a total of 40 subprime-related securities lawsuits filed.

In 2008, the lawsuits against banks and other mortgage originators continued to mount, but the litigation activity spread beyond just residential mortgage and real estate issues. The litigation also involved student lenders, commercial construction companies, commercial real estate investment trusts, bond insurers, and mortgage guaranty insurers. As I noted at the time (refer here), by early 2008, the litigation activity was no longer just about the subprime meltdown but had by that time become a credit crisis litigation wave.

The litigation wave also picked up considerable momentum during 2008, driven in part by the onslaught of cases involving auction rate securities. A total of 21 separate auction rate securities lawsuits were filed in 2008, against broker dealers, security issuers and mutual funds, among others. There were also a significant number of separate securities lawsuits filed on behalf of preferred shareholders and subordinated debtholders, which represents a relatively unusual securities litigation development, as discussed here.

The crisis in the global financial markets during fall 2008 also significantly affected the litigation wave. As I noted here, as a result of the financial market turmoil, the litigation wave reached an "inflection point" during the third quarter of 2008, where companies began to find themselves exposed to litigation not because of their own direct vulnerability to the credit crisis, but because of the companies’ exposure to other companies that were experiencing credit crisis-related issues.

During 2008, a total of 101 subprime and credit crisis-related securities lawsuits were filed.

As 2009 has begun, the litigation wave has shown no sign of slowing down. Indeed, during January 2009 alone, there were eleven new credit crisis-related securities lawsuits. A spreadsheet of the 2009 cases can be found here.

One important consequence of the litigation wave’s evolution over time is that it has become increasingly difficult to maintain absolute definitional clarity about what should be included in the category. This challenge has become even more difficult now that the financial crisis basically encompasses the entire global economy. It has become progressively tricky to determine whether or not newly filed lawsuits logically ought to be group together with the earlier suits, or whether they represent something entirely different. This categorization challenge has made simply "counting" the subprime and credit crisis-related lawsuits increasingly more difficult over time.

Financial Sector Concentration

Though the litigation has evolved and become more diverse, the litigation activity has largely been concentrated in the financial sector. Of the 152 subprime and credit crisis-related securities lawsuits that have been filed as of February 4, 2009 and that involved companies or other entities that have assigned standard industrial classification codes (SIC Codes), fully 117 of them have involved companies or other entities with SIC Codes in the 6000 series (Finance, Insurance and Real Estate).

Moreover, the 18 entities that have been sued but that have no SIC Code designated are also almost exclusive concentrated in the financial sector. These entities include mutual funds, private equity firms, hedge funds, and foreign firms whose shares do not trade on U.S. exchanges (e.g., Fortis and Société Générale).

Of the financial companies, the SIC Code categories with the largest number of lawsuits were SIC Code 6021 (National Commercial Banks) and SIC Code 6798 (Real Estate Investment Trusts), both of which had 16 lawsuits. Other categories with a significant number of securities lawsuits include SIC Code 6211 (Security Broker Dealers), which had 13 lawsuits; SIC Code 6189 (Asset Backed Securities), which had 12 lawsuits; and SIC Code 6035 (Savings Institutions, Federally Chartered), which had 11 lawsuits.

Has the Wave Entered a New Phase?

But while the litigation activity has largely been concentrated in the financial sector, there has more recently been a "new wave" of credit crisis lawsuits, as discussed at greater length here. These new wave lawsuits involved companies exposed to some of the credit crisis casualties (Lehman Brothers, Fannie Mae, Freddie Mac, Washington Mutual, American International Group, etc); that made wrong-way bets on commodities or currencies; and companies outside the financial sector whose balance sheets are laden with auction rate securities or other troubled assets.

The interesting question these new wave cases present is how far outside the financial sector these kinds of cases will spread as we go forward.

How are the Cases Faring?

Even though the subprime and credit crisis-securities litigation wave is about to enter its third year, most of the cases are still only in their earliest stages. There has really been only one significant settlement, the recent massive $550 million settlement involving Merrill Lynch (about which refer here). The few other settlements have been considerably more modest (refer here).

Only a handful of these cases have even reached the motion to dismiss stage. Among the cases where dismissal motions actually have been addressed, there have been several notable cases in which the dismissal motions were denied – for example, the New Century case (refer here) and the Countrywide case (refer here).

On the other hand, there have also been a handful of cases in which the motions to dismiss have been granted, and at least some courts have seemed skeptical that the target companies financial woes were the result of fraud (about which refer here).

My complete list of subprime and credit crisis-related securities lawsuit settlements, dismissals and dismissal denials can be found here.

Looking Ahead

Even though the litigation wave is about to enter its third year, it is clear that we have still only just begun. With the cases already filed only in their earliest stages and with new lawsuits continuing to pour in, the subprime and credit crisis-related litigation wave is likely to continue to remain an important feature of the litigation landscape for years and years to come.

 

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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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Since I first began chronicling the subprime litigation wave in April 2007 (here), the wave has gained amplitude and speed. But a spate of recent subprime-related litigation developments, seemingly unrelated, suggest that the litigation wave's magnitude has crossed a significant threshold. Things seemingly have changed, decidedly for the worse.

The first development that makes me think things have worsened is the lawsuit that has been filed against Levitt Corp., which is described in the plaintiffs' counsel's January 25, 2008 press release (here). Although there are several noteworthy things about this lawsuit (as discussed further below), the significance to me of this lawsuit for the larger issue of the subprime litigation generally is the lawsuit's purported class period, which extends from January 31, 2007 to August 14, 2007. That is, the allegations in the complaint related to events that took place several months ago.

Most of the prior subprime-related lawsuits up until now have been filed in the immediate flash of dramatic subprime-related disclosures, on some occasions even on the same day. The arrival of a lawsuit based on more remote events suggests that plaintiffs' lawyers have now begun a grim process of backing and filling, completing a more comprehensive sweep of the subprime landscape.

The impression that we have entered a backing and filling phase that will entail an expansion in the scope of subprime litigation is reinforced by recent developments in the subprime-related securities lawsuit pending against Countrywide Financial Corporation. According to a January 25, 2008 press release (here), issued by New York Comptroller Thomas DiNapoli, who is one of the co-lead plaintiffs in the Countrywide securities lawsuit, the plaintiffs in that case have filed an amended complaint that, among other things, adds as defendants "26 different financial services companies that underwrote Countrywide stock and bond offerings, [and] two global accounting firms."

The 26 financial services companies are listed in the press release. The two accounting firms named are Grant Thornton LLP and KPMG LLP. According to the press release, by expanding the suit, the plaintiffs "seek to ensure that the underwriters and accounting firms who participated in the marketing of Countrywide securities to the public are held accountable for their actions." A copy of the Countrwide complaint can be found here. Special thanks to Adam Savett of the Securities Litigation Watch blog for supplying a copy of the complaint.

A third development suggesting that the stretch and sweep of the subprime litigation wave has amplified is the subprime-related securities lawsuit I previously noted (here) and that was filed last week against National City Corporation, a regional bank holding company based in Cleveland. Unlike many other subprime-related lawsuits, which have largely (although not, of course, exclusively) involved financial firms in New York, Florida and California that have experienced gargantuan writedowns or losses, the National City lawsuit involves a company in the hinterlands that experienced substantial but not nearly as massive writedowns and losses.

These disparate events are at one level unrelated. But the pattern I detect is the suggestion that plaintiffs are expanding the field of the companies and defendants they are targeting. Companies like Levitt, that seemingly were bypassed in the earliest stages. Defendants like the financial services companies and accountants in the Countrywide case, whom the plaintiffs' lawyers just didn't get to in the initial pleadings. And secondary targets like National City.

All of this suggests to me that the subprime litigation wave has entered a more encompassing and potentially more devastating phase. Up until now, plaintiffs have concentrated on what one plaintiffs' attorney recently called the "low hanging fruit." But these most recent lawsuits suggest that the threat now extends more broadly. The impression is that the subprime wave will hit not just the biggest obstacles but could inundate a much broader area of the landscape. The destructive force of the wave could prove to be even more catastrophic than seemed likely, even a short time ago.

One final observation about the changing menace of the subprime wave actually relates to a consequence from subprime litigation. That is, this past week saw the first subprime-related downgrade of a mainstream property and casualty insurer (about which refer here), in part because of the carrier's exposure to mortgage default risk though a former bond insurer affiliate, and in part because, as one rating agency noted, of the insurer's "subprime exposure through its D&O and E&O liability portfolio on both a primary and reinsurance basis."

The rating agency went on to note that this D & O and E & O exposure "gives rise to concerns that there may be a potential resurgence in claims for these lines as they relate to subprime issues in the future." More ominously, the rating agency noted that "adverse developments" in these insurance lines beyond the rating agency's expectations "will result in further rating actions." Clearly I am not the only one concerned that things have gotten bad, and could get worse.

As I noted above, there are other interesting things about the Levitt Corp. lawsuit. The first is that the lawsuit combines not just one, but two of the recent securities litigation trends. That is, it is not only a subprime-related securities lawsuit, but it is also a securities lawsuit arising out of a failed merger. I have previously noted, most recently here, there has been a recent surge of lawsuits arising from failed deals.

According to the plaintiffs' lawyers' press release (here), the Levitt Corp. lawsuit relates to the failed 2007 merger of the company with BFC Financial Corp. Levitt had announced the planned merger to great fanfare on January 31, 2007 (here), but on August 15, 2007, the company announced (here) that the merger agreement had been terminated (according to the plaintiff's lawyers' lawsuit press release, "without giving any explanation.").

The plaintiff's lawyers' press release goes on to state that the complaint alleges that

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