The current global financial crisis may result in "unprecedented levels of litigation" that "will either serve to identify ‘weak links’ in the chain of participants who originate, appraise, and service collateral and underwrite, manage, insure, rate and sell securities," or it will serve to "highlight where the market may have underappreciated certain risks or failed to appreciate certain circumstances," according to a paper featured in a March 17, 2009 post (here) on the Harvard Law School blog.


The paper, entitled "Legal and Economic Issues in Litigation Arising From the 2007-2008 Credit Crisis," was written by Babson College Professor Jennifer Bethel, Harvard Law Professor Allen Ferrell, and Babson Professor Gang Hu, can be found here.


The paper explores the "economic and legal causes and consequences of the 2007-2008 credit crisis." In particular, the paper examines "the risks that can arise from financial and technology innovations and losses that are uniquely related to correlated events in the setting of loan markets." The paper sets for a detailed and interesting overview of the economic and financial causes that contributed to the current credit crisis.


The paper also notes that "the credit crisis is not solely an economic phenomenon, but a legal one as well." The paper discusses a number of different types of lawsuits that have arisen, but focuses in particular on securities class action lawsuits against public companies, which the paper describes as "by far the most important litigation likely to arise out of the credit crisis."


The paper asserts that "plaintiffs that bring Rule 10b-5 class action lawsuits will face substantial challenges," and notes in particular that the securities plaintiffs will have to navigate around three basic legal principles: "(i) there can be no ‘fraud by hindsight’; (ii) there can be no actionable disclosure deficiency with respect to information the market already knew (the ‘truth on the market’ defense); and (iii) plaintiffs must establish loss causation for their claims."


First with respect to the "fraud by hindsight" concern, the paper notes that it will not be enough for plaintiffs to show that there have been economic losses; they will also have to show that the adverse developments were reasonably foreseeable at the time the supposedly disclosures were made. The authors note that


Whether a failure of certain market participants to provide detailed disclosures regarding the implications of an event – the first full national fall in housing prices since World War II in conjunction with a dramatic and increasingly global crisis – from which the actors themselves suffered huge losses is actionable will likely prove an important stumbling block, in our judgment, for a number of actions being brought.


The authors add that "the presence of disclosure failures and materiality thereof must be assessed in light of what was known at the time of the disclosures without the benefit of 20/20 hindsight, even if losses occur."


Second, with respect to the "truth on the market" defense, the authors question whether the target companies in fact had "special knowledge that was not known by the market at large." The authors suggest that this may have been a situation where the market was at least as informed, or at least no less informed, than the defendants on relevant issues.


Third, the authors suggest that "loss causation is likely to be a challenging litigation issue for plaintiffs, because market prices, especially of financial-sector securities, declined overall."


The few dismissal rulings that have accumulated so far provide at least some support for the authors’ theories. In at least two cases where dismissal motions have been granted with prejudice – the NovaStar Financial case (about which refer here) and the Impac Mortgage case (refer here) – the courts seemed particularly concerned that the defendant companies had been caught in an industry-wide or even economy-wide downturn. Even if the courts did not use the price phrase "fraud by hindsight," the concept was seemingly implied in the rulings.


At the same time, however, there have also been significant cases where courts have had no difficulty denying dismissal motions – for example, New Century Financial (refer here) and Countrywide (here) – in which the courts have expressed open outrage regarding the alleged misrepresentations and omissions. The authors’ analysis seems deficient to me to the extent it fails to recognize the possibility that at least some courts’ judgments potentially may be affected by this sense of outrage, particularly over the extent of damage done, to investors and to the economy. (A list of all of the subprime dismissals and dismissal motion denials can be accessed here.)


In addition, given the authors overall hypothesis that plaintiffs will face substantial hurdles in pursuing these cases, it seems a noteworthy and even odd omission that the authors detailed and exhaustive paper neglects to even mention the possibility that the U.S. Supreme Court’s decision in the Tellabs case could also represent a significant hurdle for the plaintiffs. In that regard, the Tellabs decision has generally proven instrumental in those cases where dismissal motions have been granted thus far.


Finally, with respect to the authors’ suggestion that loss causation issues may prove critical, I note that in a prior post (here) I discussed the challenge that plaintiffs may face where they have sued for supposed economic losses on securities that continue to provide scheduled interest payments on time and in full. These arguments may be particularly relevant in claims brought by mortgage-backed securities investors who have sued the securities issuers and the securities offering underwriters.


Defenseless: Laura Pendergast-Holt, the erstwhile Chief Investment Officer of Stanford Financial Group, has a few legal problems to sort out. First, she is a defendant in an SEC enforcement proceeding involving the Stanford Group. Second, she was arrested on February 26, 2009 and charged with obstructing a proceeding before an agency of the United States. Third, she has been named as one of the defendants in numerous civil lawsuits brought by irate Stanford group investors. (A complete list of Stanford-related litigation can be accessed here.)


Ms. Pendergast-Holt clearly needs the services of an attorney. Unfortunately, she is also party to one more lawsuit, one in which she is the plaintiff, and which suggests the challenges she may have in providing for her legal representation in the above matters.


On March 17, 2009, she filed a lawsuit in Texas (Dallas County) District Court against Stanford Group’s directors and officers’ liability insurer, alleging that the insurer has "failed and refused to provide a defense so that she can defend herself in the SEC action, the civil class action, and in the criminal matter." A copy of her Original Petition can be found here.


Ms .Pendergast-Holt seeks a judicial declaration of coverage. Arguing that she has no way of satisfying any self-insured retention, she also seeks a "declaration that any self-insured retention or deductible be waived, held inapplicable or enjoined." She also alleges breach of contract and bad faith. She seeks damages estimated to exceed $5 million, as well as punitive damages estimated to exceed $40 million.


The bases on which the insurer has declined coverage for Ms. Pendergast-Holt’s defense are not specified in her Original Petition. While the scandal surrounding Stanford Group is notorious, as yet there have been no verdicts and no guilty pleas, nor to my knowledge have there even been any admissions. Whatever the facts ultimately prove to be, nothing has as yet been determined. These considerations may prove relevant to the coverage dispute, for example, with respect to the potential applicability of policy exclusions. On the other hand, representations made in connection with Stanford’s policy application (particularly with respect to Stanford’s finances) may also figure into the insurer’s coverage position.


A March 18, 2009 AmLaw Daily post regarding the coverage lawsuit can be found here. Hat tip to the Courthouse News Service (here) for a copy of the Original Petition.