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

In the past week, plaintiffs’ lawyers filed a raft of new subprime and credit crisis related securities lawsuits. The cases involve a wide variety of claimants and defendants, and a diverse array of legal theories. But while the lawsuits themselves are diverse, they do all evidence a common theme, which is that the subprime and credit-crisis related litigation wave continues to surge on.

American International Group: The most prominent lawsuit filed in the past week is the securities class action lawsuit filed in the United States District Court for the Southern District of New York against American International Group, its CEO Martin Sullivan, its CFO Steven Bensinger, and two other officials. A press release describing the lawsuit, which was filed by the Bernstein Litowitz Berger & Grossmann firm on behalf of the Jacksonville Police and Fire Pension Fund, can be found here. A copy of the complaint can be found here.

According to the press release, “Defendants repeatedly reassured investors that AIG had successfully insulated itself from the recent turmoil in the housing and credit markets due to its superior risk management. In particular, defendants touted the security of [American International Group Financial Products] ‘super senior’ credit default swap portfolio, making numerous statements that this portfolio was secure and that AIG’s method for accounting for this portfolio accurately reflected its value.” The press release goes on to state that:

Investors began to learn the truth regarding AIG’s financial condition and the Company’s exposure to the mortgage market when, on February 11, 2008, the Company disclosed that its outside auditor had determined that there was “material weakness in its internal control” over the financial reporting and oversight relating specifically to its accounting for the CDS portfolio, and that the Company was revising the loss valuations it previously reported. Under the new valuations, losses on the CDS portfolio more than quadrupled – from the $1.4 billion reported on the CDS portfolio just weeks before to over $4.5 billion. Two weeks later, on February 28, 2008, AIG disclosed that the market valuations on the CDS portfolio would increase to $11.5 billion and revealed for the first time that the Company had notional exposure of $6.5 billion in liquidity puts written on collateralized debt obligations (“CDOs”) linked to the sub-prime mortgage market.

Finally, on May 8, 2008, the Company disclosed that market valuation losses on the CDS portfolio for the quarter climbed an additional $9.1 billion, for a cumulative loss of $20.6 billion, and that the Company was expecting actual losses on the portfolio to be about $2.4 billion. As a result of these disclosures, the price of AIG stock plunged from a Class Period high of $75.24 per share on June 5, 2008, to $38.37 per share on May 12, 2008, wiping out tens of billions of dollars in shareholder value and causing damage to the class.

A May 22, 2008 New York Times article describing the AIG lawsuit can be found here. A May 23, 2008 Law.com article about the suit can be found here.

Falcon Strategies/Citigroup: Another prominent lawsuit filed during the last week involved a hedge fund affiliated with Citigroup, which is also a defendant in the lawsuit. The lawsuit is filed on behalf of all persons “who have tendered or been asked to tender their shares” in Falcon Strategies Two LLC. According to the plaintiffs’ lawyers’ press release (here), Falcon was established as a “multi-strategy fixed income alternative seeking to provide investors with absolute returns, current income and portfolio diversification.” However, the complaint (which can be found here) alleges that Falcon was “not conservative” but “employed bond arbitrage, carried commercial debt obligations, and held asset-backed mortgage investments” that declined in value when the markets failed.

The complaint is somewhat unusual in that, which it alleges affirmative violations of the federal securities laws, it does not expressly seek damages, but rather seeks a preliminary injunction to enjoin the tender offer until the defendants correct the “allegedly false and misleading” tender memorandum.

A separate lawsuit against a Falcon Strategies fund seeking damages and filed on behalf of Fifth Third Bank is detailed in a May 20, 2008 Wall Street Journal article (here). The Falcon Strategies fund had previously been the target of a separate securities class action lawsuit, but that lawsuit was voluntarily dismissed (refer here concerning this prior dismissed lawsuit).

The Falcon Strategies lawsuit is the second subprime or credit crisis-related securities class action lawsuit brought against a Citigroup-affiliated hedge fund. In early May 2008, investors brought a securities lawsuit against MAT Five LLC, Citigroup and other defendants alleging misrepresentations in MAT Five’s placement memorandum (Refer here for further background regarding the MAT Five lawsuit.)

Bank of America: In addition to these two lawsuits, investors also brought a securities class action lawsuit against Bank of America and related entities on behalf of all persons who purchased auction rate securities from the defendants during the period May 22, 2003 and February 23, 2008. A copy of the plaintiffs’ lawyers’ press release can be found here and a copy of the complaint can be found here.

I have written extensively about the auction rate securities lawsuits in prior posts, most recently here.

National City/Harbor Bank: Finally, in the fourth of last week’s flotilla of new subprime lawsuits, on May 20, 2008, the defendants removed to the United States District Court for the Northern District of Ohio a lawsuit that had been filed in the Court of Common Pleas of Cuyahoga County Ohio on behalf of all persons who acquired shares of National City Corporation in connection with National City’s December 1, 2006 acquisition of Harbor Bank. A copy of the complaint and removal petition can be found here.

The plaintiffs allege that the Registration Statement issued in connection with the merger contained material misrepresentations and omissions concerning National City’s lending practices, financial results and liquidity. In particular, the complaint alleges among other things that the Registration Statement failed to disclose that National City was “dangerously overexposed” to “risky and impaired CDOs” and that the company had “failed to properly account for its highly leveraged loans and mortgage securities.”

National City previously has been sued in a securities class action lawsuit (as I discussed in a prior post, here) filed on behalf of its shareholders. But this new lawsuit is filed on behalf of a distinct set of claimants and is based on a different set of alleged misrepresentations, and therefore in my view it represents a separate new lawsuit. As discussed below, I have accounted for it separately in my running tally of subprime-related securities lawsuits.

The lawsuits against National City on behalf of the former Harbor Bank shareholders alleges violations of Section 11 of the ’33 Act, but was filed initially in state court under the ’33 Act’s concurrent jurisdiction provisions. I have previously noted (refer here) the plaintiffs’ lawyers’ recent interest in attempting to pursue ’33 Act claims in state court. While defendants routinely remove these cases to federal court, the plaintiffs’ lawyers’ have has some success in having the cases remanded to state court (refer here). While one can only speculate on the plaintiffs’ interest in pursuing these cases in state court, it is nonetheless a very interesting development that possible represents a new trend in securities litigation prosecution.

One other interesting thing about the National City/Harbor Bank lawsuit is that in addition to National City itself and its current and former directors and officers, the complaint names as a defendant, National City’s auditors, Ernst & Young. There have been some lawsuits where the target company’s outside auditors have been named as defendants (for example, refer here regarding the amended complaint in the Countrywide subprime litigation where the companies’ auditors have been named). The bankruptcy examiner in the New Century case also suggested that there may be claims against the company’s auditors (refer here for a discussion of this report). However, so far, the auditors have been an infrequent target, likely because of the Stoneridge decision. The cases involving outside auditors have tended to be bases where an offering of securities is involved, and the auditors potentially have their own primary liability in connection with the offering.

Special thanks to Adam Savett of the Securities Litigation Watch blog (here) for a copy of the National City/Harbor Bank complaint.

Run the Numbers: With the addition of last week’s four new subprime and credit-related securities lawsuits, the current tally (refer here) of the subprime related securities lawsuits now stands at 85, of which 45 have been filed in 2008. With the addition of the new Bank of America lawsuit, the total number of auction rate securities lawsuits now stands at 17.

While the numerical specifics are important, the more important point is that the subprime and credit crisis-related litigation wave continues to churn on, the passage of time apparently doing nothing to diminish its intensity.

Speakers’ Corner: On Thursday May 29, 2008, I will be in New York speaking on a panel at IQPC’s 4^th Securities Litigation Conference (brochure here). The panel on which I am participating is entitled “Discussing Recent Trends in Director & Officer Liability (D&O) Liability,” and includes as co-panelists Ray DeCarlo of AIG and Adam Savett of RiskMetrics.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

According to the plaintiffs’ attorneys’ press release,

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

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

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

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

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

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

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

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

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

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

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In prior posts (here and here), I noted two subprime securities lawsuit rulings in which defendants’ motions to dismiss were granted with leave to amend. But in a January 4, 2008 order (here) in the Accredited Home subprime-related securities lawsuit pending in the United States District Court for the Central District of California, the defendants’ motions to dismiss were largely denied, except with respect to certain of the outside director defendants’ dismissal motions.

The lead plaintiff in the case is the Arkansas Teacher Retirement System. The corrected consolidated class action complaint can be found here. Background regarding the case can be found here. The complaint names as defendants the company, a subprime-mortgage lender; its mortgage REIT subsidiary; five individuals who served as executives at the company or the REIT; and five individuals who had served as outside directors on the company’s board.

The complaint contains three basic sets of alleged misrepresentations: first, that the company maintained certain loan underwriting standards, when, it is alleged, the standards were in fact lax and were even undermined by the individual defendants; second, that the company maintained adequate reserves and allowances, when, it is alleged, that its reserves in fact did not adequately take into account the deterioration of the company’s mortgage loan portfolio and were even reduced as the portfolio deteriorated, resulting in an overstatement of the company’s earnings; and three, that the company misleadingly accounted for goodwill in connection with its May 2006 acquisition of Ames Investment Corp.

The plaintiffs asserted claims under Section 10 of the ’34 Act (and Rule 10b-5 thereunder); Section 14 of the ’34 Act (and Rule 14a-9 thereunder); and Sections 11, 12 and 15 of the ’33 Act.

In ruling on the motions to dismiss, Judge Marilyn Huff separately assessed the allegations against the various defendants. Judge Huff found that the complaint’s allegations as to the company and the five officer defendants adequately pled that the alleged misrepresentations were false and misleading. In making this finding, the court relied on the “group pleading doctrine,” which the court found properly applied to the officers since the individuals had “direct involvement with the company’s day-to-day affairs and financial statements.”

But Judge Huff declined to extend this finding to the outside directors or to the REIT. Judge Huff said that the complaint “fails to establish any basis for attributing statements” to these defendants. Accordingly, Judge Huff granted the motion to dismiss the Section 10 claims against the outside directors and the REIT.

Judge Huff also found that the complaint adequately pled scienter as to the five officer defendants and the company. She cited the complaint’s allegations that these individuals had “access to periodic reports that included detailed information regarding widespread deviations from company policy” and the allegations from several confidential witnesses that the defendants “actually directed these deviations.” Judge Huff also cited the allegations that the defendants “caused or permitted large decreases in several significant reserve accounts” in violation of GAAP while at the same time aware of the mortgage portfolio’s deterioration.

Judge Huff also found that the plaintiffs had adequately pled materiality, reliance and loss causation. Judge Huff denied the motions to dismiss the Section 14 claim, largely on the same grounds as with respect to the Section 10 claim, although once again she separated out the outside director defendants and granted their Section 14 dismissal motions. She denied the motion to dismiss the ’33 Act claims as well, although she again separated out the outside directors and granted their motion to dismiss the section 12 claims against them .

Special thanks to an alert reader, who felt that if I were going to write about the dismissals granted, I also had to write about the Accredited Home dismissal denial, to which he referred me.

Motion to Dismiss Denied in Comverse Options Backdating Securities Lawsuit: On February 19, 2008, Judge Nicholas Garaufis entered an order (here) denying the defendants’ motions to dismiss the Consolidated Amended Complaint (here) in the Comverse Technology options backdating securities lawsuit. Refer here for background regarding the case.

The motions actually came in the form of an appeal from the prior report and recommendation of Magistrate Judge Ramon Reyes, to whom the court had referred the case.

Significantly, Judge Garaufis reversed the Magistrate Judge’s recommendations in one significant respect. The Magistrate Judge had recommended dismissal of the Section 10(b) claims against the three outside director defendants who had served on the board’s audit and compensation committees. The court found that the three individuals’ “knowledge and experience” coupled with “red flags” evident in the board consent forms, made it “at least as plausible” that the three “were aware of, but ignored a strong likelihood of wrongdoing when the signed the unanimous consent forms.”

The court affirmed the Magistrate Judge’s recommendations in all other material respects.

The plaintiffs’ lawyers’ press release describing the dismissal order can be found here.

I have added the Comverse Technology order to my list of options backdating lawsuit dismissals, denials and settlements, which can be accessed here.

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Doomsday estimates of subprime related write-downs of as much as $400 billion, at a time when current Wall Street losses are “only” around $120 billion, beg the question of where the rest of these losses are. Undoubtedly, some part of these as yet unannounced losses will be revealed in many financial institutions’ upcoming earnings releases, as discussed in the February 19, 2008 New York Times article entitled “Wall St. Banks Confront a String of Write-Downs” (here).

But Wall Street woes alone do not encompass the universe of potential losses. As discussed in the February 11, 2008 Financial Times article entitled “The $280bn Question: Where are the Rest of the Subprime Bodies?,” (here), the question that “everyone is trying to work out is where the rest of the bodies are.” The Financial Times article notes that:

Outside Wall Street, suspicions are rife that other institutions are still concealing losses…In particular, there is now rising concern about so-called “buyside” institutions, or entities that have been purchasing mortgage-linked securities in recent years, rather than selling them on. “The problems are moving from the sellside to the buyside – that is where the losses are still to be recognized,” one structured finance expert told a conference in London last week.

There have been some buyside disclosures, the most prominent of which at this point is Bristol-Myers Squibb’s recent $275 write-down of auction rate securities (about which I previously commented here). Whether and to what extent these kinds of write-downs will spread to other nonfinancial companies remains to be seen.

The observers monitoring these developments apparently include plaintiffs’ securities attorneys. A February 19, 2008 Reuters article entitled “Subprime Lawsuits Seen Hitting More Industries” (here) reports that plaintiffs’ attorneys expect that investors lawsuits “likely will spread beyond the financial and housing sectors, as more companies reveal write-downs linked to bad mortgage investments.” The article quotes Salvatore Graziano of the Bernstein Litowitz law firm as saying that “we expect non-real estate companies to start being impacted by this.” He added that his firm has “already gotten a number of inquiries from clients” who are suffering losses from investments they thought were very safe.”

Graziano specifically mentioned the Bristol Myers write-down, commenting that shareholders could potentially bring legal claims against companies that take these kinds of write-downs if the assets were not previously properly valued. He added that “what Bristol-Myers did puts a lot of pressure on the auditors for other companies. That’s why I expect a lot more in coming quarters.”

Graziano also mentions AIG’s recent announcement of potential losses of up to $5 billion in its derivatives portfolio. “I think AIG, without reaching an ultimate conclusion, is a case we’re interested in looking at further.”

More About Auction Rate Securities: In a recent post (here), I discussed the possibility of claims arising from problems connected with auction rate securities. A separate February 19, 2008 Reuters article entitled “Marketing of Auction Rate Securities May Bring Lawsuits” (here) notes that “banks and brokers could face a wave of lawsuits from clients who claim they were not properly told about risks in the now nearly frozen auction rate securities market.” The article quotes Graziano as saying that he has heard “concerns from institutional investors that funds invested in auction rate securities carried an inappropriate level of risk for the kinds of investments they authorized brokers to make.”

Along those same lines, on February 15, 2008, the Miami law firm of Diamond, Kaplan & Rothstein announced (here) that it is “investigating claims involving investment losses in auction rate securities.” The press release specifically mentions broker-dealers that sold auction rate securities, including Lehman Brothers, Goldman Sachs, Merrill Lynch, Citigroup and UBS.

And Then There are the Rating Agencies: One of the recurring themes arising in discussions about subprime issues is the question of the potential liability of the rating agencies (which I discussed most recently here). Jim Peterson at the Re:Balance blog has an interesting discussion (here) of the issues surrounding the rating agencies involvement in the subprime meltdown. Peterson takes the position that the credit rating agencies may not be able to “dodge the bullet” this time. (Peterson is a financial and accounting columnist for the International Herald Tribune.)

Speaker’s Corner: Readers interested in subprime related issues will want to know about two upcoming conferences on the subject. First, IQPC is holding a conference entitled “Subprime and the Credit Crisis” on February 26-27, 2008, in New York City. (agenda here). I will be moderating a panel entitled “Exploring Potential D & O Insurers’ Liability.”

And on March 6, 2008, Mealey’s is sponsoring an event in New York entitled “Subprime-Backed Securities Litigation Conference,” the agenda for which can be found here. I will be speaking on the topic of “CDOs, Asset Valuation and Subprime Litigation So Far.”

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The subprime meltdown has already provoked a wave of shareholder lawsuits (as detailed here), in which public company shareholders have alleged subprime-related misrepresentations or omissions that shareholders contend inflated the companies’ share price. But the plaintiffs in an unusual class action securities lawsuit recently filed in Massachusetts state court are not public company shareholders but rather mortgage-backed securities investors who have sued the securitizers who created, issued and underwrote the securities.

In a complaint filed on January 31, 2008 in Suffolk County Mass. Superior Court (here), the Plumbers’ Union Local No. 12 Pension Fund has brought a lawsuit under Section 11, Section 12 and Section 15 of the Securities Act of 1933. The Fund has brought the lawsuit on behalf of itself and the class of investors who purchased mortgage-pass through certificates in connection with Nomura Asset Acceptance Corporation’s July 29, 2005 and April 24, 2006 issuance of hundreds of millions of dollars of the certificates. The defendants in the lawsuit include Nomura Asset and certain of its directors and officers; the eight Delaware trusts in which the underlying mortgage assets were held; and the six investment banks that underwrite the offerings, including Nomura Securities, Goldman Sachs, Merrill Lynch and Citigroup.

The plaintiff alleges that the Registration Statements and Prospectuses issued in connection with the offerings contain false and misleading statements concerning the underwriting standards that would apply to the mortgages to be included; the borrower qualifications to be applied; and the collateral requirements and appraisal standards. The complaint alleges that the actual lending and other practices fell far below the standards described in the Registration Statement, and as a result the assets in the pool “had a much greater risk profile than represented in the Registration Statement.”

The complaint alleges that beginning in the summer of 2007, “the truth about the performance of the mortgage loans that secured the certificates began to be revealed.” The delinquency rates of the underlying mortgages “have skyrocketed.” Several classes of the certificates were downgraded in July 2007 and again in December 2007. The complaint alleges that as a result of the underlying assets’ deteriorating performance, the certificate investors “should receive less absolute cash flow in the future and will not receive it on a timely basis.” In addition, the complaint alleges that the certificates “are no longer marketable at prices anywhere near the price paid” and the investors are “exposed to much more risk with respect to both the timing and absolute cash flow to be received than the Registration Statement …represented.”

There have been prior subprime-related cases brought by mortgage-backed securities investors against the financial institutions that packaged and sold the mortgage instruments. Probably the most prominent example is the case of Bankers Life Insurance Company v. Credit Suisse First Boston, et al., pending in the United States District Court for the Middle District of Florida (amended complaint here). In that case, Bankers Life also alleges misrepresentations in connection with the issuance of certain mortgage-backed pass through certificates. But the Bankers Life case is an individual action, not a class action. In addition, the Bankers Life case does not allege violations of the federal securities laws. Bankers Life alleges negligent misrepresentation, common law fraud, breach of contract, and breach of fiduciary duty, among other things.

UPDATE: An alert reader who prefers anonymity points out another action by a mortgage-backed asset investor against securitizers is the Luminent Mortgage Capital v. Merrll Lynch case pending in the Eastern District of Pennsylvania (complaint here). Luminent alleges that the defendants misled investors concerning certain mortgage loan asset-backed certificates they offered and sold to Luminent. Luminent asserts claims under Section 10(b) of the '34 Act, Section 12 of the '33 Act and state law claims of fraud, misrepresentation, negligence, breach of contract and rescission.

So far as I know, the Nomura Asset case is the first class action and the first federal securities case in connection with the current subprime meltdown where mortgage-backed asset investors have sued the mortgage securitizers. (There may well be other federal securities class actions, about which readers are encouraged to let me know .)

UPDATE: Obviously, the Luminent case refered to in the update above asserts claims under the federal securities laws. In addition, an alert reader has brought to my attention another federal securities law class action, captioned as Luther v. Countrywide Home Loans Servicing, originally filed in Los Angeles Ca. County Superior Court, later removed to federal court. The federal court case is now pending in the Central District of California under Civil No. 07-8165. The removal issues are discussed further below. In the Luther case, as in the Nomura Assets case, the plaintiff asserts claims that the defendants omitted material information about the mortgage pass through certificates they sold. The plaintiffs assert claims on behalf of themselves and the class of other certificate purchasers under Sections 11, 12 and 15 of the '33 Act. Because of the similarities between the Luther case and the Nomura case, the issues surrounding the Luther case are highly relevant to the issues discussed below regarding the Nomura caqse.

The lawsuit is unusual in another respect, which is that it is a federal securities class action lawsuit brought in state court.

The filing of the federal class action lawsuit in state court cannot be written off as the misguided action of some backwater law firm. The plaintiffs’ firms on the complaint include the Coughlin Stoia firm and the Shapiro Haber & Umry firm. I think the only fair assumption is that these lawyers made a deliberate and informed decision to file this case in state court. Which of course begs the question: why?

It is late here at blog central, and there aren’t many people around at this hour with whom I can discuss this question. So I am left to my own meager speculation, which I have set out below. My speculation probably reveals little except my own ignorance of the securities laws. But these are the only reasons I can come up with to explain why this case was filed in state court.

Presumably, the plaintiff intends to rely on the concurrent state court jurisdiction provision in Section 22(a) of the ’33 Act. Whether or not this case is removable to federal court under the Securities Litigation Uniform Standards Act (SLUSA) also seems to be addressed in Section 22(a), which provides that other than with respect to “covered class action” under SLUSA, “no case arising under this title brought in any state court of competent jurisdiction shall be removed to any court of the United States.”

The jurisdictional argument thus turns on whether this is a “covered class action” under SLUSA. The language of SLUSA, codified in Section 16(b) of the ’33 Act, defines a “covered class action” as one “based upon the statutory or common law of any State or subdivision thereof” containing specified allegations in connection with the purchase or sale of a security. The plaintiff will undoubtedly argue that the claims in this case are brought only under federal law, not under the “statutory or common law of any State” and therefore SLUSA does not apply, and the case can therefore remain in state court under the ’33 Act’s concurrent state court jurisdiction.

But even if I am right about this jurisdictional argument (and I will be the first to concede that my jurisdictional analysis could be 100% wrong), that still does not answer the question why the plaintiffs would choose to avail themselves of the state court jurisdiction in the first place, even if it is an available jurisdiction. The best guess I have is that the plaintiffs may intend to argue, under the provisions of the Private Securities Litigation Reform Act (PSLRA) codified into Section 27(a)(1) of the ’33 Act, that the PSLRA applies only to private actions “brought as a plaintiff class action pursuant to the Federal Rules of Civil Procedure.” The plaintiff’s argument may be that because the case was not brought pursuant to the Federal Rules of Civil Procedure, the various provisions of the PSLRA do not apply – for example, the discovery stay or the lead plaintiff provisions. In other words, the plaintiff is proceeding in state court to try to circumvent the hurdles and obstacles of the PSLRA.

An alternative theory is that the plaintiff filed the action in state court to try to circumvent the Supreme Court’s recent holding in the Stoneridge case (about which refer here). But the plaintiff’s claims against the offering underwriters are not based on scheme liability or aiding and abetting theories. The plaintiff is asserting that the various defendants each violated their respective primary duties under the ’33 Act. So it does not appear that the state court filing is an attempt to get around Stoneridge.  

My speculative analysis might be completely wrong. But there has to be some reason why these experienced plaintiffs’ attorneys filed this suit in state court. I have tried to come up with the most plausible theory I could thing of. I welcome readers’ thoughts and commentary, particularly any alternative theories as to why this lawsuit was brought in state court.

UPDATE: As mentioned above, the Luther v. Countrywide Homes case is also a federal securities law action that was filed in state court. Defendants removed the case to federal court and the plaintiffs have moved to remand the case back to state court. The memorandum in support of the plaintiffs' remand motion can be found here. The plaintiffs argue that the sole basis on which defendants sought to remove the case is the Class Action Fairness Act of 2005, not SLUSA as I had speculated. The plaintiffs argue that Section 22(a) affirnatively forbids the removal of state court '33 Act cases to federal court and that CAFA did not change that and does not apply to '33 Act cases. The remand petition will be argued on February 25, 2008.

In any event, it has seemed likely it was only a matter of time before mortgage-backed securities investors pursued federal securities class action lawsuits against the financial institutions that were involved in packaging the subprime mortgages into investment securities. The Nomura Asset case, even though brought in state court, may well portend a whole new category of subprime-related securities litigation. UPDATE: With the added reference to the Luther case, the conclusion that there may be a whole new category of securities cases seems even stronger.

This case poses one other problem for me, which is whether or not to include it in my running tally of subprime related securities lawsuits (which can be found here). While I have faced other definitional issues in maintaining the tally, the one issue that all of the cases have in common is that they were all brought against public companies by the public companies' shareholders. This case obviously represents something different. Nevertheless, because it is a subprime-related securities lawsuit, I have decided to include in the running tally. Even if I did not forsee all of the kinds of securities litigation that would arise in connection with the subprime meltdown, I did undertake to capture all of the subprime-related securities litigation. So I have added it to the list, even though reasonable minds could disagree over whether it belongs there. UPDATE: I have also added the Luther case to the list as well.

The addition of the Nomura lawsuit to the list brings the total of subprime-related securities lawsuits to 45, including eight so far in 2008. To the extent future developments warrant, I may separately tally the subprime-backed securities investor lawsuits from the shareholder lawsuits. UPDATE: The addition of the Luther case brings the total to 46

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On February 7, 2007, New Century Financial Corp. became the first company to be named in subprime-related securities lawsuit. On January 31, 2008, just short of one year later, Judge Dean Pregerson of the United States District Court for the Central District of California, granted the defendants’ motions to dismiss, but without prejudice and with leave to amend. For background on the lawsuit, refer here. For a copy of the January 31 opinion, refer here.

The plaintiff shareholders had initiated the complaint following the company’s February 7, 2007 announcement (here) that it would be restating its financial statements for the quarters ended March 31, June 30 and September 30, 2006, because of the company’s need to readjust the company’s allowance for “the potential repurchase of loans resulting from early-payment defaults by the underlying borrowers.” The company said that the reserve did not allow for the discounted price the company sustained upon its disposition of repurchased loans. The company’s press release also said that

the company’s methodology for estimating the volume of repurchase claims to be included in the repurchase reserve calculations did not properly consider, in each of the three quarters of 2006, the growing volume of repurchase claims outstanding.

On April 2, 2007, the company announced (here) that it had filed for relief under Chapter 11 of the U.S Bankruptcy Code. The company’s shares ultimately declined more than 97% percent.

On September 14, 2007, the lead plaintiff in the subprime-related securities lawsuit pending against New Century, the New York State Teachers’ Retirement System, filed a consolidated class action complaint. The consolidated complaint names as defendants the company and certain of its directors and officers; the company’s auditor, KPMG, and investment banks that underwrote the company’s June 2005 and August 2006 preferred stock offerings. The consolidated complaint raises allegations against all defendants under Section 11 of the ’33 Act, and against the company and its directors and officers under Section 10 of the ’34 Act.

In assessing the plaintiffs’ allegations, Judge Pregerson said that the complaint “lacks clarity in articulating the grounds for its claims.” The complaint “does not clearly identify the allegedly false statements or which of the factual allegations support and inference that particular statements are false or misleading.” The court attributed these shortcomings to the “lack of organization and somewhat unclear presentation of the allegations.” As a result, Judge Pregerson said, he “has difficulty determining whether plaintiffs have stated a claim.”

Judge Pregerson granted the motions to dismiss but allowed the plaintiffs leave to amend their complaint, by which the plaintiffs may attempt to “resolve deficiencies in the complaint by simple reorganization, revision and clarification of the currently long and at times meandering set of allegations.” The court instructed the plaintiffs that for each of the supposedly false or misleading statements, “the Complaint should identify some facts suggesting that the statement is false or misleading.” The court also directed the plaintiffs to attach to their amended complaint a chart specifying each allegedly false or misleading statement, the supporting factual allegations and the plaintiffs’ conclusion.

Like the prior dismissal of the subprime-related securities lawsuits involving IndyMac (about which refer here), the dismissal in the New Century case is without prejudice. Judge Pregerson’s opinion in the New Century case does not reach the merits, but nevertheless shows great impatience with the plaintiffs’ scattershot pleading approach. (“The Court,” Judge Pregerson observed in a footnote, “should not have to comb through the complaint to identify reasonable inferences from factual allegations to the legal conclusions.”) The plaintiffs have until February 25, 2008 to file an amended complaint. The court has scheduled argument on the updated motions to dismiss on April 21, 2008.

And so the motion to dismiss on the first-filed subprime securities lawsuit might be ready to be decided some 15 months (or more) after the complaint was initially filed. Obviously, at this rate it will take many years before the many subprime related cases have finally ground their way through the system, and before the full impact of the still evolving subprime crisis can be fully assessed.

But it is interesting to reflect, upon review of the events leading up to the New Century lawsuit, and as the subprime meltdown continues to unfold, that as early as the first quarter of 2006, New Century was already experiencing unanticipated loan repurchase requirements resulting from early-payment defaults on subprime loans. The subprime meltdown may seem like a sudden crisis, but has actually already been years in the making and will be even longer in the unfolding. Clearly, the wheels of finance, like the wheels of the law, grind exceeding slow but exceeding fine.

Hat tip to the Class Action Defense Blog (here) for the link to the January 31, 2008 opinion in the New Century case.

Loaded for Bear: The February 15, 2008 Wall Street Journal had an interesting article entitled “Bear Probe May Center on Investor Call” (here) discussing how federal prosecutors’ investigating the collapse of two Bear Stearns hedge funds managed by Ralph Cioffi are examining Cioffi’s statements in an April 25, 2007 conference call with hedge fund investors. Readers interested in this investigation will want to refer back to the December 17, 2007 Business Week article entitled “The Bear Flu: How it Spread” (here) for further background on the circumstances under investigation.

According to the Business Week article, in the April 25 call, Cioffi made statements about a Bear Stearns branded CDO mechanism that Cioffi also managed called “Klio funding.” This mechanism sold commercial paper and other short term debt to money market funds to allow the CDO to buy other higher yielding, longer-term securities. The money market funds were willing to invest because Citigroup agreed to refund their initial stake plays interest (in a so-called “liquidity put”). Citigroup, in turn, drew fees and also was able to sell the Klios mortgage-backed securities of its own.

According to Business Week, the Klio structure spread rapidly as other hedge funds, CDO managers and bankers “followed Cioffi’s lead.” Between 2004 and 2007, Wall Street raised $100 billion through these types of CDOs, “essentially creating a whole new way for industry to finance risky subprime loans.” The article goes on to detail how the Klios offered the Bear Stearns hedge funds a “ready, in-house trading partner,” and that in many months “the Cioffi-managed Klios traded only with the Cioffi-managed Bear funds.” The daisy chain ended in disaster when the subprime loans underlying these investments began to deteriorate. Much of the subprime-related writedowns amongst the investment banks are related to the liquidity puts they provided.

The Journal article reports that in the April 25 call, one participant wondered whether the packaged mortgage securities in the Bear hedge funds were tied to subprime assets. Cioffi reportedly responded that he didn’t have time to teach “CDO 101” or answer basic questions about the securities. It is probably worth observing that the April 25 call came several weeks after New Century had (as noted above) filed for bankruptcy as a result of deteriorating subprime mortgages that were already a problem more than a year before that. The questioner’s inquiry in the April 25 call about subprime was not, as Cioffi’s belittling response suggests, the result of naïveté, but rather well-grounded concern.

Cioffi’s response, although lacking the vulgarity, calls to mind Jeffrey Skilling’s now infamous conference call statement in the fateful final months of Enron. In response to an analyst’s comment that Enron was the only company that releases its earnings statement without a balance sheet, Skilling said “Well, thank you very much, we appreciate that … asshole.” (Refer here for the details about Skilling and the infamous call.)

The comparison may or may not be fair. But every scandal needs a villain, and fair or not, it appears at least based on the news coverage concerning the collapse of the two Bear Stearns hedge funds, that the casting is now complete. It appears that during the current Act of the subprime drama that the role of villain is to be played by Ralph Cioffi, and as with those called to play the villains in prior dramas, his arrogance will be one of the things held against him.

The Backdating Disposition List, Updated: Regular readers know that I have been maintaining a list (accessed here) reflecting all backdating lawsuit dismissals, denials and settlements. I have recently updated the list to add three additional dismissals in options backdating-related derivative lawsuits, two of which are late additions of dismissals I missed last fall. The three dismissals are as follows:

Openwave: On February 12, 2008, the United States District Court for the Northern District of California granted (here) the defendants’ motion to dismiss the plaintiffs’ options backdating related derivative suit, with leave to amend. The court had previously dismissed the plaintiffs’ initial complaint, with leave to amend.The February 12 decision related to the plaintiffs’ amended complaint. The court will allow the plaintiffs another opportunity to amend.

Westwood One: According to the company’s November 1, 2007 filing in Form 10-Q (here), on August 3, 2007, the N.Y. Supreme Court granted the defendants’ motion to dismiss the plaintiffs’ options backdating-related shareholders’ derivative suit. On September 20, 2007, the plaintiffs’ appealed the court’s dismissal and moved for “renewal” under relevant statutes. The appeal remains pending.

Clorox: According to the company’s November 1, 2007 filing on Form 10-Q (here), on October 27, 2007, the plaintiffs voluntarily dismissed their options backdating-related derivative lawsuit in response to the recommendation of the company’s Board’s Audit Committee’s recommendation to the Board that the Board reject the plaintiffs’ suit demand, on the grounds that the suit was not in the best interests of the company.

Special thanks to Adam Savett of the Securities Litigation Watch blog for the information regarding the Westwood One and Clorox dismissals.

Headline of the Week: Still unexplained: why would anyone want TWO dead dogs?: From the February 16, 2007 Financial Times: “Ground-Dog Day as Woman Pays $50,000 to Clone Dead Pitbull” (here).

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On February 12, 2008, a plaintiff initiated a securities class action lawsuit in the United States District Court for the Central District of California relating to Morgan Stanley’s subprime-related woes. The complaint (here) purports to be filed on behalf of a class of persons who purchased Morgan Stanley’s shares between July 10, 2007 and November 7, 2007. The gist of the complaint is that Morgan Stanley "failed to disclose its significant exposure to losses related to the declining value of the subprime-related derivatives that the Company traded for its own proprietary account."

The purported class period ends on November 7, 2007, when Morgan Stanley announced (here) that as a result of the decline in "fair value" of "subprime related balance sheet exposures," the company’s revenues for the two months ended October 31, 2007 "were reduced by $3.7 billion." The complaint contends that "analysts and the market" had been "led to believe that Morgan Stanley’s smaller presence in the underwriting of CDOs would not lead to a major write-down."

While the complaint aspires to assert a  number of very serious allegations, the complaint also has a number of features suggesting something other than a highly engineered litigation assault.

First, the complaint does not name the company, its most senior managers, or its directors as defendants. Instead, the sole defendant named in the complaint is one individual, Gary Lynch, identified in the complaint as the company’s Executive Vice President and Chief Legal Officer. (The complaint also alleges that the company’s Internal Audit Department reports to Lynch, but the complaint does not explain the significance of that fact with relation to the complaint’s allegations.)

The complaint refers to no statements that Lynch himself allegedly made, but instead refers only to statements of Morgan Stanley itself. The allegations against Lynch are based solely on his position and responsibilities within the company. However, the complaint does not explain why Lynch should be held liable while none of the other senior company officials, who also obviously held positions of responsibility, are even named as defendants. There are no allegations that Lynch sold his shares of company stock. The scienter allegations are based solely on allegations of Lynch’s supposed actual knowledge of falsity, but there are no specific allegations of which facts he supposedly knew to be false or the basis of plaintiff’s allegations of Lynch's knowledge. It is not particularly clear why Lynch has been named. Actually, it is not clear at all.

Concerning the company’s own statements, the complaint refers only to the company’s July 10, 2007 and October 10, 2007 filings on Form 10-Q, with respect to each of which the complaint says only that "nowhere within the filing did the company adequately disclose its exposure to losses incurred from trading in its subprime mortgage-backed derivatives, CDOs or the subprime-backed security organizations for which it was responsible."

Second, although the purported class representative’s certification establishes that the plaintiff did indeed pay $17,211 for 340 Morgan Stanley shares, the plaintiff bought his shares on March 14, 2006, well over a year before the commencement of the purported class period. In other words, the purported representative of the class of persons who purchased shares between July 10, 2007 and November 7, 2007 himself bought no shares during that period. The plaintiff will obviously face certain obstacles satisfying the "commonality" requirement, as he is not even a member of the class he purports to represent.

Third, the complaint was filed in the Central District of California. Morgan Stanley’s world famous headquarters are of course located on Broadway, in the heart of New York City. The only apparent connection to California is the plaintiff’s counsel’s office, which is on South Figueroa Avenue in Los Angeles. (According to a search on Google Maps , the distance from the plaintiff’s lawyer’s office to Morgan Stanley’s headquarters is 2,782 miles, a distance that seems metaphorically apt given the attributes of the plaintiff’s complaint.)

But whatever its merits, the complaint does in fact purport to represent a subprime-related class action lawsuit. Accordingly, I have added the case to my running tally of subprime-related lawsuits, which can be found here. As reflected in my tally, the addition of the Morgan Stanley complaint brings the number of subprime-related securities class action lawsuits to 44, and also brings the total number of 2008 subprime-related securities lawsuits to seven. 

It remains to be seen whether another plaintiffs’ firm will follow up on the Los Angles attorney’s salvo and file a more, well, calibrated securities lawsuit, or if this complaint will be the only attempt. It should be noted that Morgan Stanley has already been named in a subprime-related action purportedly brought on behalf of company employees’ under ERISA in connection with their company shares in their defined contribution plans, as described in the plaintiffs’ counsel’s December 18, 2007 press release (here). As noted in my running tally, the Morgan Stanley ERISA suit is one of nine subprime-related ERISA actions.

Subprime: BIgger Than the S & L Crisis?: On February 14, 2008, Navigant Consulting released a report on the 2007 subprime-related litigation (executive summary here). Among other things, the report notes that (including all categories of lawsuits, including borrower suits, bankruptcy actions, employment claims, as well as securities cases) there were 278 subprime-related lawsuits filed in 2007.

Navigant also issued a February 14, 2008 press release (reported here) stating that, by way of  comparison of the subprime litigation wave to the litgation filed in connection with the S & L Crisis, that the 278 subprime lawsuits, all filed in a single calendar year, "already equal one-half of the total 559 actions handled by the RTC over a multiple-year period." The report's author said that “The S&L crisis has been a high water mark in terms of the litigation fallout of a major financial crisis. The subprime-related cases appear on their way to eclipsing that benchmark.”

The report also notes that, in addition to mortgage bankers and loan correspondents, subprime litigation defendants include "mortgage brokers, appraisers, title companies, homebuilders, mortgage servicers, issuers, underwriting firms, securitization trustees, bond insurers, rating agencies, money managers, public accounting firms and company directors and officers."

The report also notes that "Fortune 100 companies were named in 56 percent of cases" and around "half of all cases were filed in California and New York." Litigation, the report concludes, "is only likely to increase in 2008."

Hat tip to the WSJ.com law blog (here) for the link to the Navigant report.

Subprime Primer: One of the more daunting aspects of the subprime crisis has been the veritable outburst of obscure and confusing terminology. In a recent post, The Sox First blog published a very helpful "Crunch Time Glossary" (here) explaining a long list of the subprime-related terms. My favorite is the Ninja Loan, defined as "a loan given to a person with No Income, No Job, and No Assets." (100% of Ninja loans are now less euphemistically and less colorfully known as "nonperforming.")

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A developing breakdown in an obscure corner of the credit-market involving debt instruments called “auction rate securities” could represent the latest threat to emerge from the credit crisis. According to news reports (here and here), the absence of buyers for these securities has caused several recent auctions to fail, forced isuers to abandon their offerings or pay exorbitant rates, and stuck many holders with instruments they did not intend to keep. The declining values for these securities confronts many holders with the prospect of significant balance sheet write-offs, and presents another source of possible litigation arising from the evolving crisis. These circumstances also present more evidence to support my view (expressed most recently here) that the fallout from the credit crisis will ultimately extend far beyond just the financial sector.

 

Auction rate securities are long-term bonds or preferred stock on which the interest rates are reset periodically, usually every seven, 28 or 35 days. The interest rate resets make the instruments more like short-term securities. Holders can also sell the instruments on the reset dates – assuming there are enough buyers.

 

According to a February 13, 2008 article in the Wall Street Journal entitled “Credit Woes Hit Funding for Loans to Students” (here) the market for these securities has “gone into the deep freeze.” Roughly half of the $20 billion in these securities put up for auction on February 12 “failed to generate enough demand to sell.” Problems have been mounting for weeks. According to one commentator in a February 13, 2008 Bloomberg article entitled “Auction-Bond Failures Roil Munis, Pushing Rates Up” (here), “it’s the beginning of the end of the auction rate market.” UPDATE: The lead article on the front page of the February 14, 2008 Wall Street Journal (here) says that this "once-obscure type of bond is now sending shock waves through a broad swatch of the U.S. economy. The February 14 Wall Street Journal also has a separate article entitled "Train Pulls Out of New Corner of Debt Market" (here)

 

According to the Bloomberg article, “investor demand for the securities has declined on waning confidence in the credit insurers backing the debt.”  Whereas in the past, the broker-dealers selling the securities might have intervened to support the market, these dealers are now wrestling with balance sheet issues of their own and can’t take the risk of getting stuck with the securities. These conditions are hitting issuers, such as student lenders, who depend on these instruments to raise funds to loan to students, and municipalities, who are finding the lending costs skyrocketing. The conditions are also hitting investors that purchased the securities in the past and now fund themselves unable to sell, or with interest rate reset mechanisms that are malfunctioning.

 

The February 13 Journal article reports that the size of the auction rate securities market is “$325 billion to $360 billion,” and the Bloomberg article reports that about a third of the 449 companies responding to a May 2007 survey reported that their companies permitted investment in auction rate securities.

 

The turmoil in the market for auction rate securities is already taking a toll on some companies. As I previously noted (here), Bristol-Myers Squibb recently took an impairment charge of $275 million in connection with its investment in auction rate securities. Lawson Software also recently took a charge to adjust for the fair market value on auction rate securities. The February 14 Journal reports that 3M and US Air have also made auction rate securities related accounting adjustments. 

 

As I noted in my prior post discussing the Bristol-Myers write-down, these balance sheet issues potentially affect companies in many different sectors. As I have long said (refer here), before all is said and done, the subprime meltdown is going to be about a lot more than just the financial sector.

 

Indeed, according to a February 6, 2008 CFO.com article entitled “Subprime Woes Just Beginning” (here) Samuel DiPizza, the CEO of PricewaterhouseCoopers, says that the next wave from the subprime mortgage crisis “will flow past lenders and homebuilders and strike nonfinancial U.S. companies with forced writedowns.” DiPiazza specifically referenced the fact that “these securities sit in cash equivalent accounts of industrials; they sit in investment portfolios of pensions. We are having to deal with thousands of companies, not just a handful of big banks.” In a Reuters account of his comments (here), DiPiazza added that a "first wave" of write-downs was likely in the current audit cycle this quarter.

 

Nor does the disruption of the auction rate securities market raise only accounting and valuation issues. There have already been at least two lawsuits brought by auction rate securities investors against investment managers based on soured auction rate securities investments.

 

The first, as reported in the Wall Street Journal (here), was the Texas state court lawsuit (complaint here) brought by Metro PCS against Merrill Lynch. The lawsuit alleges that Merrill invested $133.9 million of the company’s cash in 10 auction-rate securities without appropriate authorization or disclosure and that Merrill later misrepresented the riskiness of the assets and their suitability under the company’s investment guidelines. I previously discussed the Metro PCS lawsuit here.

 

The second lawsuit, first reported Bloomberg (here), involves a FINRA arbitration complaint brought against Lehman Brothers Holdings by Brian and Basil Maher, who claim that Lehman’s investment of $286 million of the brothers’ funds in auction rate securities was inconsistent with the brothers’ stated investment objectives. UPDATE: The February 14, 2008 Wall Street Journal has a front-page article entitled "Debt Crisis Hits a Dynasty" (here) that details how the Mahers earned their fortune and  what happened after they invested a portion with Lehman. The article also describes the Mahers' arbitration complaint in greater detail.

 

Both of these lawsuits relate to an earlier freeze-up in the market for auction rate securities, in August and September 2007. The more recent market seizure is much more widespread, affects many different levels of securities, and many more investors, including corporate investors. As the PricewaterhouseCoopers CEO’s remarks underscore, many of the companies and investment funds holding these investments face complicated evaluation and accounting issues. Many companies may find themselves compelled (perhaps at their auditor’s insistence) to take asset write-downs or impairment charges. Shareholders and fund investors who may feel they were not fully informed about the balance sheet assets and valuation risks may, like the plaintiffs in the lawsuits cited above, seek legal redress.

 

But in any event, as I have long said, before all is said and done, the subprime litigation wave is going to have spread far beyond just the financial sector.

 

An excellent  February 13, 2008 CFO.com article entitled "Is Your 'Cash" in Danger" (here) discusses the current state of the auction rate securities market in greater detail (the market is "coming to a screeching halt") and discusses the valuation and accounting implications for companies that hold these securities on the balance sheets. My prior post regarding asset valuation issues in the context of the current credit crisis can be found here.

 

Opt-Out Lookout: As I have tracked the rising significance of securities class action opt-out settlements (most recently here), I have tried to discern whether or not the rash of recent opt-out cases was a temporary phenomenon or more enduring. And while it does not definitively answer the question, the recent analysis on the Securities Litigation Watch blog (here) regarding the opt-outs from the Tyco class action settlement provides some very interesting additional data.

 

According to the SLW, 288 class members excluded themselves from the class settlement (which was finally approved on December 19, 2007). While not all the opt-outs have filed individual actions (yet), so far 88 institutional investors and high net worth individuals have joined in a total of five separate opt-out complaints. The opt-outs include several high profile mutual fund families and investment fund groups, as the SLW details at length.

 

The presence of such a significant number of opt-outs certainly suggests that opting out may prove to be a more enduring phenomenon. On the other hand, the fact that the specific class settlement involved is the Tyco securities case means that we will have to await another day to assess whether the opt-out phenomenon is merely an attribute of the corporate scandals or will become a standard fixture of all securities class action settlements.

 

A Rare Spectacle -- Securities Litigation Trials: Another interesting recent phenomenon was the surprising recent coincidence of two securities class action trials, in the JDS Uniphase case and the Apollo Group case. In the latest issue of InSights (here), I take a more detailed look at these two trials and analyze their possible significance.  

 

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Over the past several weeks, several industry observers and analysts have tried to put a number on the insurance industry's aggregate subprime-related loss exposure. At one end, Bear Stearns on January 24, 2008 estimated the industry's exposure at $8-9 billion (refer here). By contrast, on February 8, 2008, Lehman Brothers estimated (here) that the insurance industry's losses might range up to $3 billion, and on February 6, 2008, Advisen announced (here) that it will be releasing a report estimating that the industry's ultimate losses at $3.6 billion.

I don't envy these experts whose job it is to try to quantify something as big, amorphous and evolving as the subprime-related litigation wave. Nor do I profess to have any particular insight into whose estimate is more accurate or what the ultimate number will be. I do have some observations about some considerations that are or should be being taken into account in making these kinds of estimates, in light of the circumstances surrounding the evolving subprime meltdown. (I should add that in making these observations, I have not had the benefit of reading the entire Advisen report, which as of this writing is not yet available; I have only had an opportunity to review the press release summary.)

In general, I think the various estimates have correctly noted that a potentially large portion of the amounts to be paid in settlements or judgments in the subprime litigation may not represent insured loss. In particular, the observers have correctly noted that many of the largest commercial and investment banks that are involved in the subprime-related litigation carry very large self-insured retentions and also often carry only Side A insurance programs (covering only nonindemnifiable loss, unlikely to occur here for these entities) or in some cases no insurance at all for certain exposures. These various observers have made a number of other valid observations concerning other factors that could restrict the impact of subprime losses for D & O insurers.

But at the same time, it seems to me that there are a number of other considerations that these observers have undervalued or even overlooked in assessing the possible impact of the subprime meltdown on insurers.

First and foremost, I think it is important to stress that we are only at the very earliest stages of the emergence of the subprime-related litigation. To be sure, there are (as documented here) already 43 subprime-related class action lawsuits, as well as nine subprime-related ERISA lawsuits, but before all is said and done, there are going to be many, many more of these and other kinds of lawsuits. We have not even completed the first round of subprime loss truth-telling (refer here), and it is probable that there will be even further deterioration in the mortgages underlying the subprime-backed assets as homeowners find it easier to walk away that to continue to pay down debt on a house that is declining in value (about which refer here).

As Couglin Stoia attorney Sam Rudman observed at last week's PLUS D & O Symposium, there are likely to be more securities class action lawsuits in 2008 than any year since the passage of the PSLRA (Rudman is himself already involved as plaintiffs' counsel on many of the subprime-related lawsuits).The subprime-related litigation wave is likely to continue to emerge well into 2009 and possibly beyond (just as the options backdating litigation wave continues to emerge). The possible extent of this future litigation threat may be discerned from the recent litigation commenced against the Cadawalader firm (about which refer here), in which the allegations relate to commercial mortgage securitization documents the firm prepared in 1997. In other words, any dollar estimate of the possible subprime-related insurance losses should be accompanied by a healthy appreciation of how little of the ultimate amount of subprime-related litigation we can currently even see. Since we still don't know how big of an event this ultimately will be, and because it is likely to be years before we have clear idea, any attempt at quantification should carry some very substantial caveats.

Second, many of these estimates seem to presume that the insurance industry's subprime-related losses will be limited to the financial institutions sector. I do not think this is a conservative assumption. To the contrary, I think it should be assumed that the subprime-related litigation wave will both spread beyond subprime and beyond the financial sector (as I discuss at greater length here). The recent securities class action lawsuits against student loan company SLM Corporation (about which refer here) and Levitt Homes (about which refer here) underscore that the claims have already spread. Bristol Myers Squibb's recent $275 million write-down for subprime-related investment losses (refer here) further highlights that the credit crisis is no longer just about the financial sector. The possibility of further credit-related losses in many sectors outside the financial sector, and for ensuing claims, at this point seems likely -- or at least that would appear to be the conservative assumption.

Third, much of the analysis of the insurance industry's exposure has been concentrated largely (although, it must be recognized, not exclusively) on potential losses for D & O insurers. To be sure, the growing number of subprime-related securities class action lawsuits represents a very substantial threat to the D & O insurance industry. But the potential for insured losses in coverage lines outside of D & O could also be very substantial. By way of illustration, State Street's recent $618 million charge for anticipated subprime-related litigation expenses was in connection with lawsuits that do not (as discussed in my recent post, here) appear to implicate D & O coverage, but that could present significant fiduciary liability or even investment management E & O losses.

By the same token, the recently revised complaint in the subprime-related securities litigation involving Countrywide (about which refer here) added accountant liability claims, as well as claims against Countrywide's offering underwriters. Other professionals undoubtedly will find themselves caught up in subprime related litigation, including, for example, lawyers; hedge fund and pension fund managers; mortgage brokers; appraisers and surveyors; real estate brokers; and insurance agents, among many others. The cumulative losses from claims against other professionals could be very substantial, and at this early stage particularly difficult to prognosticate.

Even with respect to the analysts' breakdown of the likely D & O losses, the breadth of the current and likely future claims may or may not be being fully taken into account. That is, while it is true that some of the lawsuits against the largest financial institutions may not, because of the way that these entities structure their insurance, involve the prospect for insured losses, most of the current and likely future subprime litigation defendants do not have these types of insurance arrangements. As the claims spread to secondary players and targets in the hinterlands (about which refer here), the claims are hitting defendants that have more traditional insurance structures. Those (far more numerous) claims may involved a greater percentage of insured losses than (the relatively few claims, as a percentage matter) against the largest banks and financial institutions.

Fourth, I am well aware that one of the issues with which these analysts have had to grapple is the need to try and put the subprime meltdown into context. The challenge is not just to say how it compares, for example, to the S & L crisis or the bursting of the dotcom bubble, but also to come up with a figure for those prior events in order to compare the current subprime crisis. I don't have data for those prior events, but I do know that the still unfolding options backdating scandal may present a useful comparison. As I have detailed in another post today, the options backdating losses, on the few cases that have been resolved so far, already represent in aggregate some very impressive numbers. There are many more options backdating cases yet to be resolved. The total options backdating related losses are likely to by very substantial. Given that just about everyone assumes that the subprime related crisis represents an even greater threat to insurers than the options backdating scandal, the implication is that the subprime related losses could be very significant indeed.

Fifth, whatever else might be said, nothing meaningful about the extent of the subprime threat can be derived from the D & O insurers' current marketplace behavior. My comment here relates specifically to the comment in the Lehman Brothers report linked above that "if insurers were concerned about suffering multi-billion dollar subprime D & O losses that could spread outside financial institutions sector, the market would tighten significantly." If the D & O industry had a long track record of skillfully adjusting its prices to changing exposures, this remark might have greater validity. Unfortunately, the industry's consistent history suggests that the industry is only capable of disciplining itself when losses become so painful that it is forced to change its ways. The current D & O pricing environment is a reflection only of the amount of available capacity, not of any calibration to emerging exposures. The marketplace will remain competitive until cumulating losses force the changes of necessity, and then any changes would be abrupt and disruptive -- as they have always been in the past.

Sixth, as most of the analysts have noted, the defense expense associated with the subprime cases in and of itself could be staggering. As an example of how expensive these cases can be, Apollo Group recently reported (here) that it had spent $25 million dollars taking the securities lawsuit pending against the company through trial. Because of the legal and factual complexity surrounding the subprime cases, they could be extremely costly to defend. Much of the associated defense expense, other than for the large investment bank defendants, is likely to be covered loss. For each of the securities cases, the defense expenses are likely to be many millions of dollars, and, for the cases in the aggregate (including those already filed and those yet to be filed), to be many hundreds (and possibly thousands) of millions of dollars. To these costs must be added the costs of defending the claims raised against other professionals.

Finally, it would be unfortunate if the subprime hype were to obscure the fact that the subprime-related litigation is only one of several very important current developments affecting D & O insurers' exposure. As I have noted elsewhere (refer here) securities litigation levels would be elevated compared to the prior two years' activity levels even without the subprime-related litigation. The Securities Litigation Watch blog recently noted (here) that January 2008 securities activity remained at elevated levels, only in part because of the subprime related litigation. None of this could be discerned from D & O insurers' current conduct. It has been ever thus.

Blog Warning: This week I hope to be making some long needed adjustments to The D & O Diary. While these changes are taking place, I will not be adding any new blog posts (although the current posts will remain available). These adjustments should result in several improvments to The D & O Diary. I will report further on the adjustments once they have been completed.

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As I have previously noted (here), securities backed by subprime and other residential mortgages are not just held by financial companies. A wide variety of companies invested in these securities in order to try to improve their return on cash and short-term investments. As the credit markets have deteriorated, many of these investments have declined in value, and the companies holding these investments have been forced to take write-downs or charges. The most dramatic write-downs have come from companies in the financial sector. But now companies outside the financial sector are announcing downward accounting adjustments, and some of these accounting adjustments are occurring in some unexpected places.

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In a prior post (here), I noted that the subprime meltdown story is no longer just about subprime, and that the crisis spreading to other types of credit could stretch the subprime litigation wave to areas outside of subprime. The lawsuit filed today against SLM Corporation (better known as "Sallie Mae") officially brought the subprime litigation wave to the student lending arena.

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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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On January 22, 2008, National City Corporation, a Cleveland-based bank holding company, announced (here) a fourth quarter loss of $333 million, including a write-down of $181 million on its mortgage business and a $691 million provision for credit losses. On January 24, 2008, the company was hit with a securities class action lawsuit.

According to their January 24 press release (here), the plaintiffs' counsel filed a complaint (here) against the company and certain of its directors and officers in the United States District Court for the Northern District of Ohio.

According to the plaintiffs' counsel's press release, the complaint alleges that:

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In response to the developing credit crisis, politicians have proposed legislative fixes and, more recently, advocated the need for fiscal stimuli. Some politicians of a more aggressive cast have launched investigations (about which refer here). In this environment, it is hardly surprising that other politicians are also resorting to litigation - and not merely to recoup supposed subprime-related losses, but also to extract political gains from the current turmoil.

The most substantial examples of subprime-related litigation as political theater are from Ohio. Exhibit One is the case filed last week in the Northern District of Ohio (Youngstown Division) against the Federal Home Loan Mortgage Corporation (Freddie Mac) on behalf of the Ohio Public Employees Retirement System (OPERS). A copy of the complaint can be found here. . For its part, OPERS apparently believes that its losses from the fraud alleged in the complaint could be as much as $27.2 million.

It is the lawsuit's context rather than its relative merits that concern me. The first of the troublesome contextual elements is the January 22, 2008 press release that Ohio Attorney General Marc Dann issued in connection with the lawsuit's filing (here). The press release not only announces the lawsuit and describes its allegations, but also thanks OPERS "for supporting my effort to hold Freddie Mac accountable for the role the company and its top executives played in bilking investors and fueling the foreclosure crisis that is destroying neighborhoods across the state and the entire nation."

Dann goes on to say that "by authorizing me to bring the suit on their behalf," they are not only protecting pensioners' and taxpayers' interests but "sending a loud and clear message to Wall Street that this type of fraud and manipulation will not be tolerated by the people who live on Main Streets that are being devastated by what Freddie Mac has done." As may be seen from this January 23, 2008 Columbus Dispatch article (here), Dann's epistle achieved the media attention his press release so obviously sought.

An additional contextual element of this lawsuit is the venue where it was filed. Dann did not file the suit in Virginia, where Freddie Mac has its headquarters, or in New York, where its shares trade and where a prior lawsuit against Freddie Mac on similar grounds is already pending, or even Columbus, where OPERS has its headquarters. Rather, Dann filed the lawsuit in Youngstown. The critical thing to know here is that Dann is from Youngstown, and that is where he has his political base.

Now, given the uncertainties of litigation, it is entirely possible that this case will wind up being litigated in Youngstown. And it is entirely possible that this lawsuit could ultimately even gain a substantial recovery on behalf of OPERS' pensioners and other members of the purported class - indeed, OPERS already has an impressive track record against Freddie Mac, having recovered as lead plaintiff in a prior securities lawsuit against Freddie Mac a $410 million class settlement. And Dann did note in his press release that, in addition to the Youngstown lawsuit, he has also filed a lead plaintiff petition on behalf of OPERS in the previously pending New York securities lawsuit against Freddie Mac. But obviously, announcing a mere lead plaintiff petition wouldn't make for much of a press release.

Nor is Dann the only Ohio politician using subprime-related litigation to portray themselves as the scourge of Wall Street and the champion of the oppressed masses. For example, in a January 11, 2008 press release (here), Cleveland Mayor Frank Jackson announced that the City of Cleveland was initiating a lawsuit against 21 investment banks and mortgage lenders who "financed and cultivated the subprime market." A copy of the complaint can be found here.

The Cleveland Plain Dealer reports (here) that the firms are accused of "creating a public nuisance by making mortgages available to people who had 'no realistic means of keeping up their loan payments.'" The loans allegedly have resulted in thousands of foreclosures in Cuyahoga County. Jackson also told the newspaper that "to me this is no different than organized crime or drugs. It has the same effect as drug activity in neighborhoods."

The situation in Cleveland is dire, and the specter of thousands of empty, foreclosed houses haunts the city and silently testifies to its straitened condition. On that score, I am sympathetic to Jackson's frustrated desire for retribution. But it is hard to know what to say about the lawsuit's implicit suggestion that lenders should be liable for having had the audacity to lend money to the city's residents. While subprime lending undoubtedly involved excesses, and even some unscrupulous practices, the city's current desperate condition cannot possibly be improved without outside investment, and, yes, the availability of home financing, neither of which the Mayor's lawsuit does anything to encourage.

Ohio has long-standing, complex economic problems. It saddens me that, rather than confront the real issues facing the state and its people, its political leaders would rather indulge in finger-pointing and scapegoating. Whatever the merits of these lawsuits, they will do little to solve or even relieve the deep economic problems that beset the state.

These lawsuits are troublesome not only because of the squandered political leadership they represent, they are also of concern because Ohio's politicians clearly will not be the only ones tempted to seek political capital from subprime-related litigation. (Indeed, Baltimore's leaders have also filed their own lawsuit against Wells Fargo, here, alleging reverse redlining) With so many forces already adding momentum to the growing subprime litigation wave, it is truly discouraging development that politicians feel compelled to exacerbate an already appalling situation. The problems from the subprime situation will only get worse if our political leaders are more interested in assigning blame than finding solutions.

Subprime and the Insurance Market: As the subprime meltdown has emerged, one of the recurring questions has been what impact it will have on the professional liability insurance industry. The latest attempt to answer this question appears in the January 2008 issue of Risk & Insurance, in an article entitled "Will the Liability Market Turn?" (here). (Full disclosure: I was interviewed in connection with the article.) Among other things, the article quotes "one estimate" as putting the "professional liability insurance losses connected with the subprime lending mess at $16 billion."

My own thoughts on the impact on the professional liability insurance industry are reflected in a December 17, 2007 interview published in full on the Risk & Insurance website and entitled "Coverage Expert on Subprime Pricing" (here).

A Closer Look at a Busted-Buyout: In prior posts (most recently here), I have examined the lawsuits that busted buyouts have spawned. Among other deals I have examined is KKR's now canceled deal to acquire Harman International, which I discussed here. A January 23, 2008 Fortune article entitled "An Old Hand in a Strange New World" (here) takes a closer look at the failed deal, and examines the myriad of forces that led to its demise.

Of particular interest is the article's discussion of the company's increased capital spending while the deal was pending and that was the source of the "material adverse change" KKR attempted to invoke to try to scuttle the deal. Apparently, the company's German division, anticipating KKR's post-deal fiscal austerity, and exhibiting "exuberant behavior," overspent its capital budget by $25 million. The article, anticipating the presumed question, states, "no, there weren't controls then in place to prevent this."

Though KKR and Harman have resolved their legal disputes, the separate lawsuit brought by Harman's shareholders against Harman's management remains pending. In that context, the article is particularly interesting.

Now This: The Professional Liability Underwriting Society has decided to join the blogosphere, with their new blog, The PLUS Blog (here). The site has just come out of beta testing and they are off to a great start. The blog, which will focus on breaking news and features affecting the professional liability insurance industry, should be worth watching.

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On January 11, 2008, MBIA became the latest bond insurer to be named as a defendant in a subprime-related securities class action lawsuit. Bond insurers ACA Capital Holdings (about which refer here), Security Capital Assurance (refer here) and Radian Group (refer here) have previously been named in subprime-related securities lawsuits. MBIA is one of the leading triple-A rated bond insurers, and the company's difficulties may represent among the more significant developments arising from the subprime meltdown. A copy of the plaintiffs' lawyers January 11, 2008 press release regarding the MBIA securities lawsuit can be found here, and a copy of the securities lawsuit complaint, which also names MBIA's CEO and CFO as defendants, can be found here.

In addition to the securities lawsuit, MBIA's benefit plan fiduciaries were also hit with a lawsuit under ERISA, filed on behalf of MBIA employees in connection with company stock held in the employees' 401(k) plan. The plaintiffs' counsel's January 11, 2008 press release about the ERISA lawsuit can be found here. The company also disclosed on January 8, 2008 (here) that the SEC and the New York Insurance Department have started informal inquiries into the company's recent disclosures and a deal the company struck with Warburg Pincus.

The centerpiece of the securities lawsuit complaint is the company's December 19, 2007 detailed accounting (here) of its exposures to collateralized debt obligations, a disclosure that contained information the complaint describes as a "bombshell." According to the complaint, in the December 19 release, the company "disclosed for the first time that it faced $8.1 billion of exposure from insuring some of the riskiest securities in the marketplace - collateralized debt obligations (CDOs) comprised of other CDOs (so-called "CDOs squared" securities) whose underlying collateral included residential mortgage backed securities (RMBS)." The complaint alleges that "with this disclosure, investors learned for the first time that Defendants had placed their triple-A rating in jeopardy."

The company's December 20, 2007 press release (here) attempted to respond to the market criticism and reaction that followed the December 19 disclosure. Nevertheless, the company later came under further pressure when it announced on January 9, 2008 (here) that the company actually held $9 billion of the CDO squared securities, rather than the $8.1 disclosed just weeks before and that, according to the complaint, "nearly 60% of these securities were originated in 2006 or later (which was material because recent vintages are defaulting with greater consistency) and that the portfolio had already caused a $200 million impairment."

The MBIA securities lawsuit is the first subprime-related securities lawsuit of 2008. In light of the magnitude and recency of the events involved in the lawsuit, it seems likely that there will be further developments, both with respect to the company itself and in general. While it is obviously still quite early, the MBIA lawsuit does at least suggest that the 2007 subprime-related securities litigation wave was not, as some have suggested, a one-time event.

I have in any event added the MBIA lawsuit to my running tally of subprime-related securities lawsuits, which may be found here. With the addition of the MBIA lawsuit, the current tally (including subprime-related securities lawsuits pending against the credit rating agencies and against residential home construction companies) stands at 38. With the addition of the MBIA ERISA lawsuit, the number of subprime-related ERISA lawsuits stands at 9.

My prior discussion of bond insurers' exposure to subprime risk, including a detailed discussion of the securities lawsuit that has been filed against ACA Capital Holding, can be found here.

CDOs Squared: I have previously noted (most recently here) that among the contributing factors to the subprime meltdown are the complicated investment instruments into which mortgage loans were repackaged and sold in the global financial marketplace. The MBIA complaint's allegations about CDOs squared underscore this point rather impressively. MBIA (and other bond insurers) played a particularly critical role in the viability of these instruments, since MBIA's willingness to provide insurance against the instruments' default enabled the instruments to carry MBIA's AAA rating making them acceptable even to conservative investors.

Readers who like me do not feely fully briefed on CDOs squared may want to review this 2005 Nomura Securities publication (here), which explains that a CDO squared security is a type of collateralized debt obligation where the underlying portfolio consists of other types of CDOs.

According to the article,

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On January 3, 2008, State Street Corporation announced (here) that for the fourth quarter of 2007, it will be establishing a reserve of $618 million, on a pre-tax basis, "to address legal exposure and other costs associated with the underperformance of ... fixed-income strategies managed by... the company's investment management arm." The net charge to the company, "after taking into account the tax effect of the reserve and associated lower incentive compensation cost" will be $279 million.

In its January 3 press release, the company did not identify the specific litigation to which the reserve will relate; rather, the company referenced only "customer concerns as to whether the execution of [the fixed-income strategies] was consistent with the customers' investment intent." The press release goes on to state that the strategies "were adversely impacted by exposure to, and the lack of liquidity in, subprime mortgage markets."

A January 4, 2007 New York Times article entitled "State Street Corp. Is Sued Over Pension Losses" (here) states that State Street decided to create the reserve "after five clients sued it, claiming they had lost tens of millions of dollars in State Street funds they were told would be invested in risk-free debt like Treasuries." The Times article briefly identifies four of the claimants, but adds that "it was unclear who brought the fifth suit."

Because of the possibility that, as stated in the Times article, that State Street's litigation and related reserve "highlight the legal challenges that lie ahead for financial firms," it would appear to be worthwhile to review here the five State Street lawsuits. The value of this exercise is underscored by the perception (which I share) voiced by one commentator quoted in the Times article that "there could be many, many more" lawsuits like those against State Street.

The first of the five lawsuits was brought on October 1, 2007 by Prudential Retirement Insurance and Annuity Company. (I previously posted about the Prudential lawsuit here.) A copy of the Prudential complaint can be found here. According to Prudential Financial's October 1, 2007 filing on Form 8-K (here), the action "seeks, among other relief, restitution of certain losses attributable to certain investment funds" sold by State Street's investment management arm, and alleges that State Street "failed to exercise prudent investment management." The specific legal basis of Prudential's claim is that State Street and its investment arm violated the Employee Retirement Income Security Act of 1974 (ERISA).

The complaint alleges that the defendants "radically altered" the investment strategies of two bond funds, the Intermediate Bond Fund and the Government Credit Bond Fund. The complaint alleges that the funds "took undisclosed, highly leveraged positions in mortgage-related financial derivatives" and thereby "exposed" the funds to "an inappropriate level of risk" that during the summer of 2007 "produced catastrophic results." The complaint further alleges that as these events unfolded the defendants provided "untimely, incomplete and misleading information."

The Prudential complaint alleges that the defendants caused losses of "roughly $80 million" to assets held by about 165 retirement plans for which Prudential is responsible, affecting approximately 28,000 plan participants. The complaint seeks restitution and compensation for the investor losses (which Prudential has, according to an October 2, 2007 Wall Street Journal article, here, already reimbursed). The complaint also seeks recovery of fees and other amounts the defendants' received, as well as recovery of the plaintiff's attorneys' fees.

Of the five lawsuits against State Street in connection with which the company established its litigation reserve, three others (in addition to the Prudential lawsuit) allege violations of ERISA. The first of these three other ERISA lawsuits was brought on October 17, 2007 by Unisystems and the trustee of the Unisystems Employees' Profit Sharing Plan. A copy of the Unisystems amended complaint can be found here. (My prior post about the Unisystems complaint can be found here.)

The second of the three other ERISA lawsuits was brought on October 24, 2007 by the Composite Pension Trust of Nashua Corporation. A copy of the Nashua complaint can be found here.

The third of the three other ERISA lawsuits (and the fourth of the five total lawsuits brought against State Street) was brought on October 31, 2007 by the plan administrator and the trustee of the Employees' Savings and Profit Sharing Plan of the Andover Companies. A copy of the amended Andover Complaint can be found here.

The fifth of the five lawsuits against State Street (which is also the lawsuit which the Times was unable to identify) was brought on November 5, 2007 in Harris County, Texas, District Court by Memorial Hermann Healthcare System. On December 3, 2007, the defendants removed the Memorial Hermann complaint to the Southern District of Texas. A copy of the removal petition, to which the initial state court complaint is attached, can be found here. Unlike the four other State Street lawsuits, the Memorial Hermann complaint does not allege a violation of ERISA. Instead, the complaint asserts against the State Street defendants a variety of state law claims, including breach of contract, fraud and negligent misrepresentation.

The Memorial Hermann complaint essentially alleges that the State Street defendants breached an "Agreement of Trust" to serve as trustee of nearly $91 million in the plaintiff's assets. The assets allegedly were invested in the State Street Limited Duration Bond Fund, which the complaint alleges lost 37 percent of its value during three weeks in August 2007, and 42 percent of its value for the 2007 year. The losses allegedly were the result of "unjustified investments in mortgage securities without diversification and using derivatives, all contrary to the stated Investment Objectives and representations."

UPDATE: In a later post, I discuss (here) a sixth lawsuit that has been filed against State Street.

The State Street lawsuits are significant in and of themselves, but also for what they might foreshadow. As I noted above, these lawsuits may well represent the kinds of legal problems that other financial services companies may face, particularly as the mortgages backing many of these investment funds and investment securities continue to detiorate.

There are a number of other important implications from the State Street lawsuits. The first relates to the identity of the claimants - these are very large institutions suing other very large institutions. These lawsuits are not the kind of lawyer-driven stock drop lawsuits that have drawn so much ire from would be reformers. These are conservative business litigants using plaintiffs' tools seeking to recoup significant losses. These sophisticated litigants may be unlikely to accept quick compromises, and, mindful of their own fiduciary obligations, may well be unwilling to accept any compromise that does not represent a very significant percentage of the losses.

The second important implication of the State Street lawsuits is the sheer magnitude of the dollars involved, as demonstrated by State Street's pre-tax set aside of $618 million for cases that are only in their earliest stages. The State Street litigation reserve underscores the staggering exposures that these cases and others like it represent. The stakes in these cases are enormous.

The third implication derives directly from the enormity of the financial exposures involved; that is, these cases clearly have very serious repercussions for liability insurers, a consideration discussed in a January 4, 2008 Dow Jones newswire article entitled "Subprime Litigation May Dent D & O Insurers Like Chubb, AIG" (here). The article's overall conclusion - that the subprime litigation wave may represent a significant concern for D & O insurers - is a valid point that I have in fact previously considered in a prior post (here). However, while I generally agree with the Dow Jones article's overall thrust, I do disagree with some the article's premises.

The most egregious of the article's faulty premises is that the State Street lawsuits represent a D & O insurance exposure. The article disregards the fact that four of the five State Street lawsuits are brought under ERISA. The typical D & O policy contains an ERISA exclusion, primarily because exposures under ERISA are covered under a separate fiduciary liability policy, not a D & O policy.

In addition, none of the five complaints name as a defendant any individuals; there are no director or officer defendants in any of these complaints (although there are John Doe defendants named without further identification in several of the complaints). The entity coverage under the typical D & O policy provide coverage only for securities claims against insured entities, and none of the five complaints raise securities law allegations.

So, contrary to the Dow Jones article's presumption, the State Street complaints do not themselves appear to embody any particular D & O insurance threat, as in their current forms at least, they would not appear implicate the typical D & O insurance policy. To be sure, the complaints may represent serious threats to fiduciary liability insurers and perhaps even to investment management errors and omissions (E & O) insurers, and to that extent the implication would seem to be that the subprime litigation wave represents a much more extensive threat to the insurance industry beyond just D & O. All of which does indeed suggest that the subprime litigation wave is a potentially complex and serious threat to insurers generally. To that extent, at least, the Dow Jones article is correct when it states that State Street's reserve "has increased concern that insurers offering policies covering such exposures could be hit with big claims from the credit crisis."

In any event, I do agree that the subprime litigation wave represents a threat to the D & O insurers, even if the State Street lawsuits themselves may not. My prior blog posts on the potential impact on D & O insurers from the subprime meltdown can be found here and here; even though I wrote these posts months age, the analysis still appears more or less valid.

It should also be noted that there have been a number of other subprime related lawsuits brought under ERISA, primarily by employees raising allegations relating to company stock held in the 401(k) plans. A list of these employee ERISA lawsuits may be found in my running tally of subprime-related litigation, here.




The January 6, 2007 New York Times has an article entitled "Testing Investors' Faith in State Street" (here) that examines the market's curious reaction to State Street's announcement concerning its litigation reserve -- its stock price went up, hitting a 52-week high, a response that Times columnist Gretchen Morgenson is at a loss to explain.



Now This: The American Dialect Society has chosen (here) "subprime" as the 2007 Word of the Year. Pondering this development, I was moved to reflect that the subprime meltdown has moved beyond a mere financial event; it has become a cultural, social, and even political phenomenon.


Like all important phenomena, the subprime meltdown has deep roots, which arguably go back to the early 80s when the market for mortgage securities was more or less invented at Salomon Brothers, as entertainingly retold in Michael Lewis's classic, Liar's Poker. Though the events described in Lewis's book took place over twenty years ago, they resonate now with irony and sometimes even ominous portent, although much of the current resonance was perhaps unintended when the words were originally written.


The most portentous segments detail the creation in the mid-80s of the recently eventful mortgage security, the collateralized mortgage obligation (CMO), about which Lewis notes, in words that contemporary investors in Norway, Japan, Australia and the U.K might now rue, that "CMOs opened the ways for international investors who thought American homeowners were a good bet." Lewis also notes, in an observation that seems particularly ironic today, that that as a result of the innovation of CMOs, "investors now had a new, firm idea of what the price of a mortgage bond should be." Lewis goes on to describe how the Wall Street Bankers "found a seemingly limitless number of ways to slice and dice home mortgages."


Space constraints prevent doing full justice to Lewis's account, so fraught with significance in light of today's circumstances. Suffice it to say that given recent events, Liar's Poker merits and rewards a re-reading. It is as entertaining as it ever was, but the description of the invention of the market for mortgage bonds seems to matter in ways that it did not previously.


Special thanks to loyal reader Matt Rossman, who pointed out Liar's Poker's newly relevant historical value some time ago - I only recently got around to following up on Matt's suggestion to re-read the book.

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In its 2007 year-end study of securities class action trends (here), NERA Economic Consulting noted that the "sharp increase" in 2007 securities lawsuit filings was "driven in part by litigation related to subprime lending," an observation I have also noted elsewhere. Given the importance of the subprime lawsuit filings to the overall 2007 securities lawsuit picture, it is worth taking a closer look at the 2007 subprime-related securities lawsuits.

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 Updated February 1, 2010: As shown in the lists below, the lawsuits against subprime lenders are starting to mount up. This is hardly a surprising development; as the WSJ.com Law blog noted (here), law firms are already announcing their formation of subprime lending task forces and teams, just as a year ago law firms were announcing their formation of "options backdating teams." Along the same lines, on April 25, 2007, Law.com ran an article entitled "Subprime Crash May be a Boon to Attorneys" (here).

There is a growing list of lawsuits against subprime lenders arising from the deteriorating environment these companies face. The list is now sufficiently long that it seems to be time to create a running tally of the subprime lending lawsuits, as a complement to The D & O Diary's popular running tally (here) of the options backdating related lawsuits. I have linked below to the list of subprime lending lawsuits of which I am aware. This list may be incomplete, and I entreat readers to please let me know of any omission of which they are aware. I will endeavor to keep this list updated and will indicate any additions to the list in red. The legend "2008" indicates that the lawsuit was filed in 2008; items without a legend were filed in 2007.

Securities Class Action Lawsuits: To see the list of the 207 subprime related securities lawsuits, refer here. (Word Document)

NOTE ABOUT THE LIST OF CASES: As time has gone by, it has become increasingly difficult to maintain absolute categorical precision regarding what is a subprime related lawsuit. For example, the Care Investment Trust case noted above involved a mortgage trust that holds healthcare related assets. The allegation is that the company's prospectus failed to disclose the impairment of the value of certain of its assets and that the company was having difficulty obtaining warehousing financing for its investment activities. The company's woes are undoubtedly due to contagion in the credit market deriving from the subprime meltdown, but the company itself has no ties to the subprime industry. Owing to the connection of the contagion effect in the credit markets, I have included the case in the list. Reasonable minds might omit the case.

ERISA/401(k) Lawsuits:

1. Fremont General
2. Beazer Homes
3. Citigroup
4. Countrywide Financial Corp.
5. Merrill Lynch
6. UBS AG
7. Morgan Stanley
8. State Street
9. MBIA [2008]

10. Bear Stearns [2008]

11. Regions Financial Corporation [2008]

12. Huntington Bankshares [2008]

13. National City Corp. [2008]

14. Impac Mortgage Corp. [2008]

15. Sovereign Bancorp [2008]

16. Wachovia [2008]

17. First Horizon [2008]

18. PFF Bancorp. [2008]

19. Fannie Mae (2008)

20. Hartford Financial Services Group (2008)

21 Bank of America (2009)

22. IndyMac (2008)

23. American Express (2009)

24. Northern Trust Investments (2009)

25. Sterling Financial (2010)

Subprime lenders have also been sued in various lawsuits alleging that they engaged in deceptive or unfair trade practices. Recent examples involve the lawsuit pending against First Franklin Financial Corp. (here) and the lawsuit that Wells Fargo recently settled (here). While I will provide occasional updates on this post of these kinds of deceptive trade practices lawsuit, I do not propose to comprehensively catalog them here.

In at least one instance, an investment bank has been sued in connection with the bond securitization of subprime loans. According to news reports (here), Credit Suisse was sued by Bankers Life Insurance Co. in a lawsuit in which the insurer claims it lost money on the investment grade bonds backed by subprime mortgages the Credit Suisse had sold. The lawsuit generally pertains to the quality (or lack thereof) of the mortgages that backed the bonds.

There may well be other companies or kinds of companies adversely affected by the declining residential real estate market who find themselves facing securities class action or other lawsuits, as if so, I will update this post accordingly.

Readers are encouraged to suggest additional listings or references that should be added to this post.

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