There are a variety of different ways that the subprime-related litigation might be categorized. For example, the lawsuits might be grouped by type of defendant (as in my prior discussion of lawsuits against the mortgage-backed asset securitzers, here). The lawsuits might also be grouped by type of mortgage-backed asset involved (as in my discussion of lawsuits involving auction rate securities, here). Still another approach might be to look at lawsuits involving certain kinds of mortgages (as in my discussion of Option ARM mortgages, here).
An entirely different way to look at subprime-related litigation might be to follow the developments involving just a single mortgage related financial structure and to trace the litigation in which allegations relating to the structure have been raised. As shown below, just one financial structure has produced significant investor losses and left a spate of litigation in its wake.
The Mantoloking CDO: When the Mantoloking CDO 2006-1 was created in November 2006, it appeared as just one of many collateralized debt obligations (CDOs) listed in the December 4, 2006 Nomura Securities research report (here) describing recent structured finance pricings. As described in the report, the Mantoloking CDO was a $765 million CDO holding asset backed securities (ABS), on which the lead underwriter as Merrill Lynch.
Metro PCS: According to its subsequent court filing, on May 25, 2007, Metro PCS acquired $20 million in auction rate securities “consisting of Class A-2 Senior Priority Floating Notes from the Mantoloking CDO 2006-1, Ltd.” Metro PCS acquired the securities when Merrill Lynch, acting on as the company’s investment advisor, made the investment, as part of what eventually became approximately $134 million of CDO-related auction rate securities in which Merrill invested on the company’s behalf.
In the company’s October 18, 2007 Petition against Merrill Lynch filed in the Dallas County (TX) District Court (here), Metro PCS alleged that Merrill Lynch failed to advise of the company of the intended purchases prior to the acquisition of the Mantoloking securities. The company also alleges that the securities themselves were not authorized under the company’s investment guidelines. The company also alleged that Merrill Lynch had undisclosed conflicts of interest, in that it not only underwrote the initial CDO issuance, but continued to act as the sole dealer for the CDO. The company further alleges that Merrill Lynch itself had significant investments in the CDO and therefore had a vested interest in trying to maintain a market for the CDO’s securities, as a way to protect its investment.
In its February 27, 2008 financial release (here), Metro PCS disclosed that as a result of the latest round of write-downs, it was as of December 31, 2007 carrying the auction rate CDO securities investments for which it paid $134 million at a balance sheet valuation of only $36 million.
The Bear Stearns Hedge Funds: Investors in the Mantoloking CDO apparently also included the two now-bankrupt Bear Stearns hedge funds that are the center of so much controversy (and litigation). The October 22, 2007 Business Week cover article about the hedge fund’s collapse (here) reports that as the hedge funds’ condition and results deteriorated, the hedge funds’ managers “sought out increasingly esoteric bonds and other lightly traded securities that offered higher yields.” As a result, the hedge funds “were big buyers of so-called CDOs-squared – CDOs that invest in other CDOs.” The article reports specifically that “the funds at one time held $135 million of securities issued by the Mantoloking CDO, a CDO-squared.”
On December 19, 2007, when the hedge funds’ largest equity investor, Barclays Bank, sued Bear Stearns Asset Management and the two hedge funds’ individual managers (complaint here), Barclays alleged, among other things, that the hedge funds’ managers had caused the hedge funds “to become a dumping ground for especially risky assets, including numerous CDO-squared securities and other toxic assets.”
MIND C.T.I. Ltd.: The effects of the Mantoloking CDO spread far and wide, its reach including Israel-based communication services provider MIND C.T.I. Ltd.. In its February 27, 2008 filing on Form 6-K (here), MIND reported among other things that the company has as much as $20.3 million invested in asset-backed auction rate securities, on which the company had been unable to obtain third-party valuations, and for which the company may be taking asset-impairment charges in its forthcoming audited financial statements. The company noted that “the complexity of the valuation is derived from the fact that this security is collateralized by 126 structured finance transactions.”
The company’s 6-K also reports that on February 20, 2008, the company had filed a Statement of Claim with the Financial Industry Regulatory Authority (FINRA) and commenced an arbitration “against the international bank and certain employees thereof that invested …funds on behalf of the company.” According to the 6-K, the claim alleges, among other things, that:
the bank was supposed to invest the funds in highly liquid, highly safe, 28-day auction-rate securities, but — without the Company’s authorization — invested the funds in collateralized debt obligations (CDOs). In particular, the claim alleges that the bank invested the funds in a security called "Mantoloking CDO" without telling the Company that this was a CDO investment until after the purchase had already occurred. The claim also describes how, after the fact, the bank advised that the security, which has a stated maturity date in the year 2046, had been rolled "due to failed auction."
According to the 6-K, the FINRA claim includes causes of action for fraud, violation of NASD rules (in particular NASD rules relating to suitability), violation of Section 10 of the ’34 Act, misrepresentation, and breach of fiduciary duty. The 6-K reports that the claim seeks “damages and other relief from all the respondents, including return of all funds plus compensatory and punitive damages.” The 6-K does not identify the “international bank” named in the FINRA arbitration claim.
While the Mantoloking CDO seems to have generated considerable pain for its investors, the CDO was just one of many hundreds of CDOs launched into the marketplace in the last several years. Some of the investors in these other CDOs undoubtedly have experienced some of the same kind of pain the Mantoloking CDO investors have felt, and there likely will be more pain to come. If the sequence of events surrounding the Mantoloking CDO is any indication, the investors in other CDOs can also be expected to pursue litigation to redress their grievances. Just looking at how much litigation the Mantoloking CDO alone has spawned or contributed to, it certainly appears that a formidable amount of CDO-related litigation activity could be involved.
A prior post in which I discuss CDOs squared in much greater length, including the increased risk associated with CDOs squared, can be found here.
Very special thanks to Uri Ronnen of AccountingClues for the links above regarding the Mantoloking CDO.
More UBS Lawsuits: According to news reports (here), on March 5, 2008, Pursuit Partners, a Connecticut-based hedge fund, has initiated a Connecticut state court lawsuit against UBS alleging that the hedge fund made CDO investments last year based on “fraudulent concealment of material information.” The suit alleges that UBS had been in talks with Moody’s and as a result knew that changes in the rating agency’s rating methodology were imminent, yet UBS continued to market the CDOs as if the change would not occur.
The hedge fund contends that when the new rating methodology was announced on October 10, 2007, the $50 million in CDO securities in which the hedge fund has invested were “reduced to junk status,” which triggered a default clause in the underlying derivatives contract, and the hedge fund lost its entire investment. The hedge fund says that “UBS took both sides of a derivatives contract, allowing it to liquidate the CDOs without sustaining a loss of its own.”
The hedge fund’s allegations are similar to the allegations raised against UBS by HSH Nordbank (about which I previously wrote, here), in which HSH Nordbank claimed that UBS had structured a CDO-related transaction so that UBS could profit to the investor’s detriment. HSH Nordbank also claims that UBS’s Dillon Read unit had stuffed the CDO with troubled loans as a way to reduce its own losses.
In addition to the Pursuit Parnters and HSH Nordbank lawsuits, UBS has also been sued by a physician who claims that UBS sold him auction rate securities from a closed end mutual fund, Eaton Vance Limited Duration Funds. According to the March 9, 2008 New York Times article entitled "As Good as Cash Until It’s Not" (here), UBS put all of the doctor’s charitable foundation’s $1.35 million cash in auction rate securities. The doctor claims that the foundation now can no longer "help prevent AIDS in Africa or provide indigent people with laser vision correction ."
You certainly do start to get the impression that there are a lot of angry investors out there.
Subprime-Related Derivative Complaint: As I documented elsewhere (here), shareholders’ derivative lawsuits were a significant part of the options backdating-related litigation. By contrast, there have been relatively few shareholders’ derivative lawsuits filed in connection with the subprime meltdown. Perhaps the most notable subprime-related derivative lawsuit so far is the action filed last year against AIG, as nominal defendant, and certain of its directors and officers (about which refer here).
On March 4, 2008, an investment fund manager filed a shareholders’ derivative lawsuit in Delaware Chancery Court against Bank of America, as nominal defendant, and certain of its directors and officers. The complaint (here) relates to the company’s January 22, 2008 announcement (here) that it would take a fourth-quarter 2007 write-down of $5.44 billion due to the devaluation of the company’s mortgage-backed securities, primarily CDOs.
The complaint alleges that the company underwrote and invested in CDOs but failed to inform investors of the associated risks, and failed to set aside adequate reserves for possible losses. The complaint also alleges that the company issued misleading disclosures about its exposure to subprime-related losses. The complaint further alleges that the company soft-pedaled its exposure to subprime mortgages.
The complaint alleges that the defendants breached their fiduciary duties, engaged in reckless and gross mismanagement, and wasted corporate assets.
It is not entirely clear why this lawsuit was brought as a derivative lawsuit rather than as a direct claim for damages. As a derivative claim, the lawsuit will be subject to certain defenses, including in particular the demand requirement.
Hat tip to the Courthouse News Service (here) for the copy of the complaint.
Now This: In addition to being the name of a CDO, Mantoloking is also the name of an oceanfront community in New Jersey, population 423 (2000 Census). According to Wikipedia (here), Mantoloking is "the wealthiest community in the state of New Jersey," and its past residents included Katherine Hepburn and Richard Nixon. The current surfing conditions at Mantoloking can be viewed here.