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

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

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

According to the plaintiffs’ attorneys’ press release,

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

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

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

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

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

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

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

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

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

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

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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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