On October 7, 2008, in a decision that could affect other litigation relation to Countrywide Financial, Judge Sue Robinson dismissed the consolidated shareholders’ derivative lawsuit pending in Delaware federal court against the company, as nominal defendants, and ten of its former directors and officers. A copy of the October 7 opinion can be found here.

 

The plaintiffs in the Delaware federal court derivative lawsuit had alleged that the individual defendants had violated the federal securities laws’ disclosure requirements, and also had committed state law violations of breach of contract and breach of fiduciary duty. As Judge Robinson noted in her October 7 opinion, the plaintiffs’ "most serious allegation" was that the defendants caused Countrywide to repurchase $2.37 billion worth of the company’s common stock "concomitant to the sale of $373 million worth of shares personally owned by members of the Board who were in possession of non-public, materially adverse information."

 

The defendants had moved to dismiss the amended complaint based, among other things, on the plaintiffs’ failure to make demand on the Board prior to the filing of the lawsuit.

 

However, on January 11, 2008, Countrywide and Bank of America announced that Bank of America was acquiring Countrywide in a stock for stock transaction. Bank of American’s press release announcing the merger can be found here. On July 1, 2008, the merger closed and all outstanding shares of Countrywide were exchanged for Bank of America shares. Banks of America’s July 1, 2008 press release can be found here. Countrywide became a wholly owned subsidiary of Bank of America.

 

Defendants thereafter filed a further motion to dismiss, arguing that as a result of the merger, the plaintiffs were no longer Countrywide shareholders and therefore lacked standing to pursue the derivative lawsuit.

 

Judge Robinson granted the defendants’ motion, stating that "the Delaware Supreme Court has unequivocally declared that plaintiffs in derivative suits lose standing post-merger."

 

Notwithstanding several creative arguments plaintiffs raised trying to avert this outcome, Judge Robinson’s decision is unremarkable given Delaware law on the issue. The more interesting question is the impact Judge Robinson’s ruling may have on the other pending Countrywide litigation.

 

The most immediate impact may be on the Countrywide derivative lawsuit pending before Judge Mariana Pfaelzer in the Central District of California. Readers may recall that on May 14, 2008, Judge Pfaelzer issued a blistering opinion in that case largely denying the defendants’ motion to dismiss and granting plaintiffs leave to file an amended complaint regarding the few portions of the case that were dismissed. My prior post discussing Judge Pfaelzer’s opinion can be found here.

 

Among other thing, Judge Pfaelzer said in her May 14 opinion that plaintiffs’ allegations in that case create a "cogent and compelling inference that the individual defendants misled the public with regard to the rigor of Countrywide’s loan origination process, the quality of its loans, and the Company’s financial situation – even as they realized that Countrywide had virtually abandoned its own loan underwriting process."

 

The defendants in the California derivative litigation have now moved for judgment on the pleadings based on the same lack of standing argument that the defendants in the Delaware lawsuit had raised. Indeed, the parties in the California derivative litigation have already filed competing pleadings (here) with respect to the dismissal of the Delaware action. In view of the nature and tone of Judge Pfaelzer’s May 14 opinion in the case, it will be interesting to see whether she follows Judge Robinson’s ruling on post-merger lack of standing.

 

An even more interesting question is what effect, if any, these developments will have on the consolidated Countrywide subprime securities litigation, which is also pending before Judge Pfaelzer (and about which refer here). The Bank of America acquisition of Countrywide should have no impact on the standing of the securities class action plaintiffs. However, outcome of the dismissal motions in the California derivative litigation potentially could affect the context within which Judge Pfaelzer considers the motions to dismiss in the securities litigation, especially given the strong views Judge Pfaelzer previously expressed in her prior derivative lawsuit dismissal denial.

 

Oral argument on the pending securities litigation dismissal motions is upcoming.

 

Very special thanks to a loyal reader for providing copies of Judge Robinson’s October 7 opinion and related pleadings.

 

You Could Put ‘em on a List: I have added the Countrywide Delaware Derivative lawsuit dismissal to my table of subprime and credit crisis-related securities and derivative lawsuit case dispositions, which can be accessed here.

 

A Sign of the Times: In connection with a school assignment, my son conducted a census of Obama and McCain lawn signs in our community. He found that the sign that appeared on the highest number of front lawns said "For Sale." 

 

The full consequences of the dramatic recent events in the financial markets may take years to emerge, but one direct effect has already appeared – the collapse of several large financial institutions has turned preferred shareholders into securities class action plaintiffs.

 

Historically, securities class action lawsuits have been pursued on behalf of common shareholders, and to a lesser extent, the holders of public debt securities. Preferred shareholders only infrequently became involved in this type of litigation, for several interrelated reasons.

 

In the United States, the issuance of preferred shares largely has been limited to REITs, financial institutions and utilities (as noted here). Investment in these types of securities generally is limited to institutional investors. Moreover, the offering of these kinds of securities is even further limited as a practical matter to companies regarded as likely to fulfill their preferred dividend commitments (although less financial stable companies can still attempt a preferred stock offering by including a higher dividend rate).

 

Companies issuing these securities, therefore, are typically financially stable companies in industries with historically lower securities class action frequency levels. Moreover, institutional investors, who typically buy preferred securities, were, at least until the last several years, less likely to become involved in this kind of litigation. (To be sure, these generalities are not invariable, and there are certainly prior examples of securities litigation involving preferred shareholders.)

 

The remarkable recent failure of several of the most prominent financial institutions apparently has changed all that, and within the space of a few short weeks, there has been a sudden influx of securities class action lawsuits filed on behalf of failed financial institutions’ preferred shareholders.

 

Here are the four specific cases to which I am referring:

 

1. Fannie Mae Preferred Stock, Series T: The first of these recent lawsuits was filed on September 17, 2008 in the Southern District of New York on behalf of purchasers of Federal National Mortgage Association’s ("Fannie Mae") May 13, 2008 offering of 8.25% Non-Cumulative Preferred Stock, Series T. The complaint names as defendants the five offering underwriters and four directors and officers of Fannie Mae. Background regarding this case can be found here.

 

2. Freddie Mac Preferred Stock, Series Z: On September 23, 2008, plaintiffs’ counsel filed a securities class action lawsuit in the Southern District of New York on behalf of purchasers of Federal Home Loan Mortgage Corporation’s ("Freddie Mac") November 29, 2007 offering of 8.375% Non-Cumulative Perpetual Preferred Stock, Series Z. The complaint names as defendants only the three offering underwriters. For background, refer here.

 

3. Lehman Brothers Preferred Series J Stock: On September 24, 2008, plaintiffs’ counsel initiated a securities class action lawsuit in the Southern District of New York on behalf of purchasers of Lehman Brothers’ February 5, 2008 offering of Preferred Series J Stock. The complaint names as defendants certain Lehman Brothers directors and officers and the offering underwriters. For background, refer here.

 

4. Fannie Mae Preferred Stock, Series S: On October 8, 2008, plaintiffs’ counsel filed a securities class action lawsuit in the Southern District of New York on behalf of investors who between December 14, 2007 and September 5, 2008 purchased Fannie Mae’s 8.25% Fixed-to-Floating Rae Non-Cumulative Preferred Stock, Series S. The complaint names as defendants several former Fannie Mae directors and officers as well as the offering underwriters. For background, refer here.

 

These four lawsuits have several things in common, in addition to the fact that each plaintiff represents a class of preferred shareholders. All of these lawsuits involved companies that failed shortly before the lawsuits were filed. They were all filed in the Southern District. All of the lawsuits assert claims under the ’33 Act (the fourth of the lawsuits also asserts claims under the ’34 Act).

 

Another common thread of these lawsuits is that they all involve companies that already had been hit with one or more securities lawsuits filed on behalf of common shareholders. The existence of a separate plaintiff class at least potentially represents an opportunity for a different plaintiffs’ firm that may be shut out of the earlier class lawsuit to participate in the litigation assault on the affiliated persons left standing following the companies’ collapse. The existence of the separate class potentially represents a bite at the apple for these plaintiffs’ firms.

 

In earlier posts (here and here), I suggested that the volcano of events in the financial markets that began in September 2008 potentially could represent an "inflection point" in the ongoing subprime and credit crisis-related litigation wave. I suggested that as a result of these events a new group of defendants potentially could be drawn into the litigation wave. The four cases described above further suggest that a whole new group of litigants also could become involved as plaintiffs, starting with the emergence of preferred shareholders and other investor classes as class action litigants. The sheer magnitude of the losses sweeping through the marketplace undoubtedly will draw out these new classes of claimants, as these aggrieved parties seek to shift their losses "upstream" (a process I discussed here).

 

In the interests of accuracy, I should acknowledge that preferred shareholders class actions are not unknown. Indeed, just a few months ago, in June 2008, investors in Fremont General Corporation’s 9% Trust Originated Preferred Securities filed a securities class action lawsuit in the Central District of California (about which refer here). One might argue that this earlier case merely represents the advance guard for the squadron of lawsuits that came later.

 

While there may have been prior preferred shareholder lawsuits, the filing of four preferred shareholder class actions lawsuits in quick succession as a direct result of the collapse of several larger financial institutions represents a separately identifiable and categorically distinct phenomenon. It also undeniably represents a direct consequence of the unprecedented turmoil in the financial markets that began in September 2008.

 

The massive investment losses triggered by these September (and following) events are distributed across a wide variety of types and classes of investors, representing individuals and institutions, as well as holders of many types of debt and equity in many different forms and classes. Some of these aggrieved persons will seek to recover their losses in court. Further company failures (a distinct possibility) will only amplify these trends. All of which reinforces the view that one of the consequences of the enormous events of the past several weeks is a litigation wave "inflection point."

 

Run the Numbers: With the addition of the most recently filed lawsuits, my running tally of subprime and credit-crisis related securities class action lawsuits (which can be accessed here) now stands at 122, of which 82 have been filed in 2008.

 

In addition, I have added to my list of subprime and credit crisis-related derivative lawsuits (which can be accessed here), the shareholders’ derivative lawsuit filed on October 7, 2008 against Perini Corp., as nominal defendant, and several of its directors and officers. A copy of the Perini derivative complaint can be found here. (Hat tip to Courthouse News for the Perini derivative complaint.) I previously wrote here about the securities class action lawsuit that was filed earlier against Perini.

 

With the addition of the Perini complaint, my current tally of subprime and credit crisis-related derivate lawsuits now stands at 25.

 

One thing that has happened as the credit crisis has grown, spread and become a more generalized financial crisis. That is, it has become increasingly more difficult to proceed with definitional certainty about exactly what I am "counting." As the economic downturn affects more and more companies in an ever broader variety of ways, and as the general conditions become increasingly remote from the subprime-related causes, the related lawsuits are becoming less and less categorically distinct. At some point, the distinctions may no longer exist, and the counting exercise will have to be redesigned or even cease all together.

 

Who could have anticipated where all of this would lead when the subprime litigation wave first started to emerge back in February 2007?

 

Are State Court ’33 Act Cases Removeable to Federal Court?: In prior posts (most recently here), I have discussed the fact that plaintiffs’ attorneys’ have been filing subprime related ’33 Act cases in state court, in reliance on the ’33 Act’s concurrent jurisdiction provisions.

 

Lyle Roberts notes on his 10b-5 Daily blog (here), that on September 24, 2008, the Southern District of New York refused to remand the Harborview Mortgage case (which I previously discussed here) back to state court. Roberts does note that this holding is contrary to the Ninth Circuit’s decision in Luther v Countrywide earlier this year. I discuss the Luther case here.

 

With this split in the decisions there is now fertile ground for further jurisdictional wrangling. Even less clear is the reason why plaintiffs are so intent on pursuing a federal securities lawsuit in state court in the first place.

 

When asked at the October 7, 2008 presidential debate whom he would appoint as his Treasury Secretary, John McCain commented that "it’s going to have to be someone that inspires trust and confidence." The first specific name McCain mentioned was that of Warren Buffett, someone, as McCain noted, that has "already weighed in and helped stabilize some of the difficulties in the markets."

 

In some ways, it is no surprise that McCain mentioned Buffett (notwithstanding the fact that Buffett has – as McCain duly noted – publicly supported Barrack Obama), given Buffett’s prominence and reputation. And in view of Buffett’s wealth and well-known business approach, it is unsurprising that once again Buffett is in the position to offer financial aid to troubled companies.

 

But while Buffett’s mention as a potential Treasury Secretary in a time of turmoil might now be unsurprising, it is worth reflecting that there is nothing about the way Buffett achieved his wealth, prominence or reputation that was inevitable. The remarkable story of how Buffett achieved this level of respect while he accumulated his vast fortune is compellingly told in Alice Schroeder’s splendid new biography, The Snowball: Warren Buffett and the Business of Life.

 

While numerous prior authors have attempted to detail Buffett’s life, none had the benefit of direct access to Buffett himself, as well as to his blessing to contact his family and friends, as Schroeder did. In addition, because Schroeder spent five years between 2003 and 2008 gathering material and writing her book, she wound up as a percipient witness to many of the critical events of the most recent years of Buffett’s life.

 

What emerges is more literary than a mere business biography. Indeed, prospective readers should probably be forewarned that this book is not devoted to the minute exploration of Buffett’s investment philosophy or his approach to investment decisions. Readers particularly interested in that aspect of Buffett’s story would do better to read Roger Lowenstein’s excellent 1995 Buffet biography, entitled Buffett: The Making of an American Capitalist.

 

Readers who want to understand the development and character of a man who has come to embody trust and integrity at a time when those qualities are sorely lacking (particularly in the financial marketplace) will find Schroeder’s book absorbing and instructive. The power of the book is its deep appreciation of the sweep of Buffett’s life, the role of so many of the key people he befriended along the way, and its respect for the way that events and experiences shaped and changed him.

 

For Buffett devotees such as myself (full disclosure: I own Berkshire Hathaway B shares, although not nearly as many as I wish I did), the book is full of rich anecdote and fascinating detail even with respect to events well told before. For example, the details of Buffett’s childhood have been well-chronicled, but no prior account of his life so thoroughly explores the significance of Buffett’s relationship with his parents, particularly his respect for his stock broker and congressman father and his fear of his tempestuous, unstable mother.

 

As a result of Schroeder’s access, her book also discloses numerous interesting details about Buffett’s early life, such as the fact that the current paragon shoplifted extensively from the Sears near his parents’ home while his father sat in Congress.

 

In an incident full of significance given recent events, Buffett, while a ten-year old on a visit to New York with his father, visited the offices of Goldman Sachs. Who could have foreseen the role he would come to play a half century later at a critical moment in the firm’s existence?

 

And the counterparty on Buffett’s first transaction while a brand new trader at Graham-Newman investment bank — a complex arbitrage deal involving cocoa beans and cocoa bean futures — was a shrewd investor named Jay Pritzker, whose family business, Marmon Corporation, Buffett would agree to buy in a multi-billion dollar transaction in late 2007 (refer here).

 

But even more significant than these details is the overarching theme that defines the book. This book is not so much about the way Buffett accumulated wealth as it is the way he accumulated friends and knowledge and insight. The friends enriched his life and contributed each in their own way to Buffett’s remarkable personal story. The roles that Ben Graham and Charlie Munger played have been noted elsewhere but the inside account of how Munger and Buffett met, became friends and began investing together is fully explored in this book. Schroeder’s access allowed her to describe how Buffett met and became friends with Bill Gates, and even more significantly the intellectual and philanthropic interests they share.

 

Schroeder’s emphasis on Buffett’s relationships, combined with her unfettered access and her obvious preoccupation with the topic, leads her to explore Buffett’s complex relationships with the women in his life. The book makes it clear that Buffett might well not have become who he is without the influence in his early adulthood of his late wife, Susie.

 

The book also explores Buffett’s relationships with other women, including his long-time friend Astrid Menks, with whom he lived for nearly 30 years while still married to Susie, and whom he married after Susie’s death; Kay Graham, the publisher of the Washington Post, with whom he had something more than a mere business partnership; and Sharon Osberg, his bridge partner and frequent companion. Undoubtedly due to her privileged status as authorized biographer, Schroeder is very elusive about the exact nature of Buffett’s relationship with these women, as well as Susie’s relationship with her long time friend and tennis coach (to whom Susie left $8 million in a secret and surprising codicil to her will).

 

Schroeder’s exploration of Buffett’s emotional life is perhaps at its most perceptive pitch in her analysis of the events surrounding the near collapse of Solomon Brothers in 1991. In the usual retelling of the tale, Buffett is portrayed as the gallant knight riding to the rescue, saving the company by the sheer strength of his integrity. Schroeder makes it clear that these events were for Buffett horrible and extremely challenging.

 

Buffett also found these events distressing, but not because he could have lost an enormous amount of money if the company failed. Rather, the events at Solomon filled him with dread and anxiety because the events could have cost him something even more precious – his reputation. In a particularly noteworthy detail about the episode, and one that says a great deal both about Buffett and about the culture of Wall Street, the book recounts that the senior managers at Solomon, whose jobs Buffett saved, sneered that "all he cares about is his reputation."

 

Notwithstanding her privileged access, Schroeder does not by any means avoid identifying Buffett’s shortcomings. Indeed, he comes across in many ways as a stunted person, someone whose world view is so limited that no matter how important the occasion or the requirements of decorum, he cannot bring himself to eat anything but a hamburger and French fries. His perspective is so narrow that he never noticed that the walls of the guest bedroom at Kay Graham’s house, where he stayed many times, were lined with original Picassos. He also comes off as almost childlike in his extremely squeamish inability to tolerate any discussion of someone’s medical issues or other topics he found uncomfortable.

 

Buffett was forced to confront many of these issues during Susie’s final illness and death. Because Schroeder was present during many of the events surrounding Susie’s death, her description of these events take on a particularly novelistic quality. Her recounting of the events is interwoven with Buffett’s own description to Schroeder of his thoughts and reactions, feelings and emotions. The depiction of Susie’s death is moving and serves as a reminder that even great wealth is no protection against the most basic of human susceptibilities. Although we are reading about these events because of who Buffett is, it is their universal character that gives the description its power and depth.

 

It is through the characteristics such as this that the book gains its ultimate insight, which is that Buffett was not born as "Buffett" nor did he one day simply become "Buffett." Rather, Buffett has become who he is as his life has evolved, and he has been becoming Buffett and has continued to become Buffett all along the way. Consistent with the book’s metaphorical title, Buffett has accumulated many things, not just wealth, but friends, and even wisdom and insight.

 

While she admittedly had a worthy subject to begin with, Schroder has managed to do something remarkable. She has managed to take the story of one man’s accrual of enormous wealth, a feat that might seem base or even vulgar, and turned it into a tale worth pondering. Schroder’s book succeeds because she understands that what makes Buffett fundamentally interesting is not the mere fact of his wealth alone, but how he conducted himself both while he became wealthy and even after (perhaps especially after) his fortune was assured.

 

That said, this is not a perfect book. For one thing, at 838 pages (not counting endnotes and the index), it is way too long, arguably by as much as one third. By way of illustration, someone should have stopped Schroeder from reporting that Astrid had a pedicure at Canyon Ranch while Susie was recovering from surgery. And the book would have been improved without such details as the lengthy description of Susie’s visit to Bono’s Mediterranean villa. There are many other unnecessary details of the same kind.

 

I also think it is a flaw, and a surprising one too, that Schroeder does not fully discuss the history of Buffett’s investment in General Reinsurance Corporation. (Full disclosure: for several years, I was employed by a Gen Re subsidiary). Give Schroeder’s background as a PaineWebber securities analyst for the insurance industry, I expected her to have much more to say about the Gen Re transaction and the way it turned out, especially in light of the fact that it was and still is Buffett’s largest acquisition ever. In the book’s "Afterword" Schroeder explains that because of certain continuing legal issues involving Berkshire, and the possibility that she might be a witness, she does not feel entirely free to comment. But while this explanation makes the paucity of discussion of Gen Re understandable, the limited treatment of the topic does diminish the book.

 

Notwithstanding its flaws, I still enthusiastically recommend the book. The timing of the book’s arrival, coincident with all of the astonishing recent events in the financial markets, dramatically underscores the wisdom of so many of Buffett’s recurring messages. He may or may not be the right choice to be Treasury Secretary, but if his health lasts, he undoubtedly will play a significant role in many of the events to come as the financial crisis continues to unfold.

 

Regardless of how events play out, Buffett’s humor, wisdom and insight will provide useful guidance for years to come, and not just for investors, but for anyone who aspires to reach a goal and to do so with their integrity intact.

 

A Literary Afterword: The narrative sweep of Schroeder’s book and the inclusion of so many family, friends and personal details gives the book the air of a family saga, and in many ways the book has the makings of a great novel. This characteristic of the book brought to mind another great book about the conflicts of life and business within one family, Thomas Mann’s first novel, Buddenbrooks.

 

Though Buddenbrooks is set in a much different time and place (19th century Germany) and though it is much a much darker, fatalistic and negative book (its subtitle is "The Decline of a Family"), it nevertheless represents a sweeping retelling of the fortunes of one family and how business affect the lives of four generations.

 

Some might consider it more than a stretch to invoke Buddenbrooks in connection with Schroeder’s biography of Buffett. I certainly do not mean to suggest any comparison between Schroeder and Thomas Mann. But I do think the two books share a common goal. That is, both books aspire to draw moral lessons from the interaction of business and life within the context of a single family. The moral conclusions may differ significantly, but both books offer insight into the ways life can be lived, on the practical level where the business of life actually is conducted.

 

According to news reports (here), MBIA has filed a lawsuit breach of contract lawsuit in New York state court against Countrywide Financial Corp. (now part of Bank of America) alleging that Countywide made fraudulent misrepresentations about is loan underwriting standards in connection with the securitization of over $14 billion of securities for which MBIA provided default insurance and that were backed by mortgages and home equity loans that Countrywide originated.

 

MBIA alleges that based on Countrywide’s representations about its mortgage lending practices and lending guidelines, MBIA provided "credit enhancements" in connection with the mortgage backed securities, in the form of billions of dollars of trust obligation guarantees.

 

The complaint alleges that contrary to Countrywide’s representations in connection with the transactions, during the period 2005 to 2007 Countrywide engaged in a "systemic pattern and practice of abandoning its own guidelines for loan origination" as part of the company’s attempt to expand its market share, as a result of which the risk profile of Countrywide’s mortgage portfolio "fundamentally changed." The complaint further alleges that "Countrywide deliberately abandoned its own guidelines to drive up revenues from increased origination fees, securitization fees and origination fees – no matter what the cost to borrowers, investors or guarantors like MBIA."

 

The complaint further alleges that MBIA has already paid out more than $459 million on it guarantees of the securitized loans and "is exposed to claims in excess of several hundred million dollars more."

 

The Seeking Alpha blog notes (here) that this lawsuit "may be the beginning of what may be a long battle by bond insurers MBIA and AMBAC to recover losses from those responsible, a process they refer to as remediation." Both insurers have said they expect substantial recoveries "due to misrepresentations and breaches of warranty with respect to securities that they have insured."

 

The Seeking Alpha blog further notes that these kinds of efforts may be a "painful and necessary" part of the process of putting responsibility where it belongs: "Every fraudulent transaction needs to be pushed back along the chain of perpetrators to its original source, if that person or entity can be located. As much as possible, those whose dishonesty caused the losses must bear them."

 

There have been multiple other recent attempts to by other litigants to assign blame, as part of the process that seeks to upstream losses back to their source. I discuss a couple of additional examples below.

 

Special thanks to a loyal reader for links concerning the MBIA lawsuit.

 

Wisconsin Schools Sue Over CDO Losses: On September 29, 2008, five Wisconsin school districts filed a lawsuit (here) in Wisconsin state court seeking to rescind and to recoup their losses on the $200 million the school districts invested in three synthetic CDOs. The lawsuit alleges that Stifel Nicholaus & Co. and Royal Bank of Canada and their respective related entities omitted or misrepresented the true nature of the investment and of the risks involved.

 

In 2006, the school districts invested largely borrowed funds into the CDOs to help pay their non-pension retiree benefits. Stifel Nicolaus & Co. and affiliated entities allegedly brokered the deal, while Royal Bank of Canada devised the instruments and determined their value.

 

The investments have lost approximately $150 million, or three quarters of their value. The lawsuit alleges that the investment was "complex, convoluted, and opaque, and as Stifel and RBC then well knew, beyond the investment knowledge or experience of the School Districts, their school board members, and their administrators."

 

The complaint also alleges that contrary to the defendants’ representations, the CDOs were collateralized by subprime mortgage loans. The CDOs also allegedly issue credit default swap protection as an additional source of income, which increased the CDOs credit default risk, which risk the lawsuit alleges was not fully disclosed.

 

The school districts seek rescission of the CDO transaction plus damages.

 

As losses accumulate, more and more aggrieved persons will join in this process of upstreaming losses back to their source. As I have noted many times, the litigation arising the subprime meltdown is likely to take years to unfold. As these cases illustrate, the litigation is also likely to involve an ever broader array of litigants, asserting an ever more diverse range of claims.

 

The SEC Pursues a Subprime Related Claim: Private litigants are not the only ones that will participate in this process of assigning blame. The SEC also clearly intends to get into the act, as reflected in its October 3, 2008 filing (refer here) of an enforcement action against five representatives of World Group Securities. The action alleges that the defendants fraudulently sold unsuitable securities to persons whose acquisitions were financed by mortgage refinancings.

 

The SEC’s complaint alleges that the defendants moved the customers, many of whom had little education and spoke little English, from fixed-rate mortgages to "subprime adjustable-rate negative amortization mortgages." The refinancing proceeds were then invested in variable universal life insurance and other unsuitable securities.

 

The defendants are alleged to have "misrepresented the expected returns from the securities, the liquidity of the securities, and the nature of the securities and the terms of the new mortgages while failing to disclose material facts about the products."

 

At one level this new SEC enforcement proceeding may seem unrepresentative of the larger subprime meltdown owing to its particular facts. The SEC action does share several common elements with the cases described above. Like the Wisconsin school suit, the SEC action contains both disclosure and suitability allegations, and like the MBIA lawsuit, the SEC action alleges misrepresentation of the true conditions.

 

Many of the subprime-related losses are on a much larger scale than that involved in the SEC action, but the SEC action underscores how widespread and diverse the losses are. Because of the degree of excesses involved and the overall magnitude of the losses involved, the blame assigning process yet to come will be complex and protracted. The lawsuits will continue to arise and the losses continue to emerge.

 

The stock market, that omnipresent and all-purpose barometer of all human sentiment and endeavor, was back up today. So, everything’s fine, right? Congress will get back to work, pass the bailout bill (of course, we all knew we really needed it all along, it was just an election year test, you see) and then we can all go back to important things like driving our SUVs around and watching Desperate Housewives on our big screen TVs. Right?

 Perhaps.

 

There are still a few items of concern.

 

1. LIBOR:  The London Interbank Offered Rate, or LIBOR as it is more familiarly known, has gone stark raving mad. The rate measure climbed 431 basis points today, to an all time high of 6.88 percent. Bloomberg (here) quoted one commentator as saying that "any institution that hasn’t completed its 2008 funding needs by now is going to be in serious trouble. More banks are going to fail." Another trader is quoted as saying that "the money markets have completely broken down, with no trading taking place."

 

2. Hedge Funds: The Market Movers blog asks rhetorically about hedge funds (here), and in light of hedge funds’ recent dramatic underperformance, "what happens when investors decide to take their money out [on October 1], as they are generally allowed to do on the first day of any quarter?"

 

The answer, according to the Pensions & Investments blog (here), is that there could be a "bloodbath." The "body count could be as many as 2,000 hedge funds and 500 hedge fund of funds between now and the end of March."

 

As the Market Mover blog notes, the hedge fund shakeout could have enormous consequences as "thousands of hedge funds are all trying to unwind their positions at the same time." A "worst-case scenario" is that the funds that provided credit protection fail, "leaving their investors with nothing and counterparties with little."

 

3. Europe (and Beyond): You may have noticed that over the past weekend, Europe caught America’s bailout fever. Fortis, Bradford & Bingley and Dexis all required massive governmental bailouts. The Washington Post, in a September 30, 2008 article entitled "As Contagion Spreads, Moods Abruptly Shift" (here), noted that central bankers and national leaders around the globe are alarmed and on high alert. Economies throughout the world perceive themselves to be besieged.

 

Of all of the threats to the American people, there may be no greater threat right now than that the rest of the world feels so unwell that they decide to stop buying U.S. debt. The technical definition for the position we would then be in is, I believe, "screwed."

 

4. Headlines Change Daily, Dust Settles Slowly: Let’s recap. During the past three weeks, the government has assumed control of Fannie Mae and Freddie Mac. Lehman Brothers has gone bankrupt. Bank of America agreed to buy Merrill Lynch. The government bailed out AIG. Washington Mutual became the largest bank failure ever. Citigroup agreed to buy Wachovia in an FDIC-brokered rescue. Congress punted on an administration-sponsored bailout plan. Got that?

 

Any one of these events represents an enormous development with huge consequences. Taken collectively, these events are, I don’t know, choose your own metaphor, an earthquake, a tsunami, the comet hitting the planet. The consequences for the larger economy are colossal, gargantuan, choose your own adjective. It will take months, if not years, for the effects and consequences to fully emerge.

 

There are already countless examples of these forces at work, but to choose one that is likelier to be of greater interest to readers of this blog, on Monday, Fitch Ratings lowered its outlook on Hartford Financial Services Group from stable to negative due to concerns that credit market exposures are eating into the company’s capital. As discussed here, the company has significant exposures in its asset portfolio to Lehman Brothers, AIG and Washington Mutual. This is merely the most recent example. There will be many, many more.

 

Coda: In a democracy, the electorate gets the political leadership it deserves. Under current circumstances, then, I suppose it is no surprise that reelection is our national legislature’s sole priority. On Monday, they sure showed us. Ultimately, history will judge. In the meantime, perhaps Congress and the electorate will have had more leisure to assess where true interests lie. We can only hope that delay (or further inaction) will be without further consequences. We already have quite enough damn things to worry about, thank you very much.

 

And please read James B. Stewart’s October 1. 2008 column in the Wall Street Journal, entitled "A Bailout May be Unpopular, But Doing Nothing is Worse" (here).

 

Note to file: Financial crises should not occur during election years.

 

Historic Perspective: One of the great curses for any blogger is to lack anything to write about. In recent days, opposite conditions have prevailed. So much has happened of such potential significance that it is simply overwhelming. The extraordinary events of the past few days have left many of us (even verbose, opinionated bloggers like me) at a loss for words.

 

In despair of finding the time to comment on all that has happened and of finding the words to give it expression, perhaps the best approach is to rely on the thoughts of those who have been down this road before.

 

With this observation in mind, a loyal reader sent me a link to the Mark DiIonno’s September 30, 2008 column in the Newark Star-Ledger (here), which among other things, quotes at length from FDR’s first inaugural address. DiIonno’s column motivated me to track down and read the entire address, which can be found here.

 

FDR delivered the address on March 4, 1933, a dark time indeed in the nation’s history. It was in this speech that FDR said that "the only thing we have to fear is fear itself."

 

I commend the entire address, but call the specific excerpts to readers’ attention:

 

Practices of the unscrupulous money changers stand indicted in the court of public opinion, rejected by the hearts and minds of men.

 

True they have tried, but their efforts have been cast in the pattern of an outworn tradition. Faced by failure of credit they have proposed only the lending of more money. Stripped of the lure of profit by which to induce our people to follow their false leadership, they have resorted to exhortations, pleading tearfully for restored confidence. They know only the rules of a generation of self-seekers. They have no vision, and when there is no vision the people perish.

 

The money changers have fled from their high seats in the temple of our civilization. We may now restore that temple to the ancient truths. The measure of the restoration lies in the extent to which we apply social values more noble than mere monetary profit.

 

Happiness lies not in the mere possession of money; it lies in the joy of achievement, in the thrill of creative effort. The joy and moral stimulation of work no longer must be forgotten in the mad chase of evanescent profits. These dark days will be worth all they cost us if they teach us that our true destiny is not to be ministered unto but to minister to ourselves and to our fellow men.

****

Restoration calls, however, not for changes in ethics alone. This Nation asks for action, and action now.

****

We require two safeguards against a return of the evils of the old order; there must be a strict supervision of all banking and credits and investments; there must be an end to speculation with other people’s money, and there must be provision for an adequate but sound currency.

 

As an exercise, picture your preferred Presidential candidate attempting to say  anything remotely approaching the foregoing in either sentiment or eloquence. Now picture your preferred Presidential candidate’s vice presidential nominee making the same attempt, if you can.

 

Elections matter.

 

Allegations that the defendant companies and their senior managers failed to disclose the hazards associated with the company’s risky investments. Allegations that management failed to account for losses on high risk investments in a timely or complete manner. Allegations that company management minimized the deteriorating values of high risk investments in piecemeal damage control statements to the marketplace.

 

Sound familiar?

 

You may be surprised to learn that these allegations do not come from a lawsuit filed as part of the recent wave of subprime and credit crisis litigation. Instead these allegations appear in a case filed against American Express and certain of its directors and offices in July 2002. Background regarding the case can be found here.

 

On September 26, 2008, Judge William H. Pauley of the Southern District of New York, considering the case on remand from the Second Circuit, granted the defendants’ motion to dismiss in an opinion (here) that may have considerable significance for the more recently filed subprime and credit crisis securities lawsuits.

 

The plaintiffs had alleged that in the late 90s, the company began investing in "high-risk, high yield debt securities such as below-investment grade bonds and collateralized debt obligations." The complaint alleges that in early 2001, the company recognized $123 million in losses during the preceding fiscal year in losses on the High Yield Debt Portfolio, and that during the first calendar quarter of 2001, the defendants became aware that the portfolio was "deteriorating rapidly." In April 2001, the company announced an additional $185 million in portfolio losses.

 

During the second calendar quarter of 2001, the second amended complaint alleges, the defendants became aware that "even the investment grade CDOs" were "damaged due to defaults in the underlying bonds." In July 2001, the company announced a $826 million pre-tax charge to recognize additional write-downs to the High Yield Debt Portfolio.

 

The plaintiffs sought to pursue claims on behalf of persons who had purchased the company’s shares between July 18, 1999 and July 17, 2001. Their second amended complaint alleged three categories of fraud: (1) false and misleading statements that the company had adopted risk management policies; (2) failure to properly account for investment losses; and (3) mischaracterizations of developments relating to the High Yield Portfolio.

 

Judge Pauley granted the defendants’ motion to dismiss the second amended complain on the grounds that the plaintiffs had failed to establish a strong inference that the defendants had acted with scienter.

 

Judge Pauley found that the allegations that the defendants were motivated to commit fraud by the senior managers’ aggressive income targets and incentive compensation "were not entitled to any weight."

 

Judge Pauley also rejected plaintiffs’ contention that defendants were "reckless" in not knowing the risks of the high yield investments and that the public disclosures of the company about those investments misrepresented that risk. Those allegations, the court concluded, "do no more than state in conclusory fashion what Defendants should have known, they are not entitled to any weight."

 

The court also rejected the plaintiffs’ allegations based on confidential sources, holding that:

None of the confidential sources specifically states that any Individual Defendants had information or access to information indicating that Amex was not properly valuing the High Yield Debt, that is risk control policies were inadequate, that Amex was violating GAAP, or that contradicted the Company’s statements in 2001.

With respect to plaintiffs’ allegations that the defendants minimized the deteriorating asset valuations through piecemeal disclosures, Judge Pauley focused on the internal efforts the Company was making to evaluate its deteriorating assets and found that "the more compelling inference is that Defendants were not acting with intent to deceive, but rather attempting to quantify the extent of the problem before disclosing it to the market."

 

Judge Pauley also found that the allegations about defendants’ examination of the High Yield Debt Portfolio "suggest that the Defendants upheld their duty to monitor," which "precludes any inference of recklessness."

 

The SEC Actions blog has a detailed analysis of the opinion, here.

 

The allegations in the American Express case contain many parallels with many of the lawsuits in the current litigation wave. Indeed the nature of the investment assets involved, including in particularly the investment grade CDOs, and the causes of the valuation declines (including the deteriorating of the bonds underlying the CDOs) bear an uncanny resemblance to many of the allegations in the more recent subprime and credit crisis related litigation.

 

With the insertion of the words "subprime mortgages," the case arguably would be indistinguishable from many of the more recent cases. Many of the more recent cases allege, like the American Express lawsuit, that the defendant companies lacked internal controls, failed to account for declining investment valuations, and soft-pedaled the seriousness of the valuation declines through piecemeal write-downs.

 

Because of these similarities, the failure of the American Express lawsuit to survive a motion to dismiss is potentially significant with respect to the more recent lawsuits. Of course, every lawsuit has its own distinct allegations, and the differences in any given case could well be sufficient to produce a different outcome.

 

Nevertheless, Judge Pauley’s scienter analysis may be particularly important to many of the subprime and credit crisis-related securities lawsuits, in view of the fact that a very large percentage of the recent cases have been filed in the Southern District of New York, where the American Express case was also pending.

 

Special thanks to Neil McCarthy of LawyerLinks (here) for providing a copy of the American Express opinion.

 

Congress, regulators and leading figures in the Bush administration worked overtime this weekend and have crafted a compromise bill that apparently will be put to a congressional vote this upcoming week. A copy of the current discussion draft (which House Speaker Nancy Pelosi says will be “frozen” in this form) that likely will be put to a vote this week can be found here.

 

At 110 pages, the current draft is significantly more voluminous than the initial three page draft Treasury Secretary Henry Paulson initially introduced last weekend.

 

 

As reflected in the bill’s summary (here), the “Emergency Economic Stabilization Act of 2008” not only provides up to $700 billion in funding to buy assets under the Troubled Asset Relief Program (TARP), it also authorizes the Treasury Department to modify troubled mortgage loans. The Act also requires companies selling assets to the government to provide warrants so that taxpayers benefit from the future growth of any company selling assets to the government. The Act also contains provisions relating to executive pay, as discussed below.

 

 

Finally, and by contrast to Paulson’s initial proposal, the Act provides for significant oversight and even for judicial review under certain circumstances.

 

 

The financial institutions able to take advantage of the Act include not only banks, but also any “savings association, credit union, security broker or dealer, or insurance company.” The assets that may be acquired include mortgage-backed assets created before March 14, 2008, a date apparently coinciding with the collapse of Bear Stearns. The Secretary, in consultation with other authorities, may also designate other assets to be included in the program.

 

 

The Act actually ranges far afield, particularly with respect to matters that historically have been viewed as internal or at most the province of state law. Section 111 of the Act specifies that when the government acquires a financial position in a participating institution, the Secretary of the Treasury “shall require that the financial institution meet appropriate standards for executive compensation and corporate governance.”

 

 

This section specifically provides that the standards for compensation and governance shall include “limits on compensation that include incentives for executive officers …to take unnecessary risks that threaten the value of the financial institution;” a “provision for the recovery by the financial institution of any bonus or incentive compensation … based on criteria that are later proven to be materially inaccurate;” and a prohibition on “golden parachutes.”

 

 

Congress apparently also wants to get into accounting practices and policy. In Section 132, the Act specifies that the SEC shall have the authority to suspend mark-to-market accounting under FASB 157. Section 133 of the Act requires the SEC to conduct a study of the effects and impacts of FASB 157.

 

 

In the days ahead, there undoubtedly will be further comment on the Act’s provisions (perhaps there will be further comment even on this blog). But more interesting than the Act’s provisions will be the Act’s practical effects. The purpose of the Act is to try to avoid financial catastrophe and to restore financial market functioning. The storm clouds that suddenly have appeared over a number of European banks, and the further questions involving U.S. financial institutions, serves as a reminder that the circumstances indeed are perilous.

 

 

In the days ahead as the Act is put to a vote, the question will be whether the ominous dynamic that has overtaken the financial markets finally relents. Unfortunately, as noted on the Real Time Economics blog (here), the economy may be in trouble regardless of the bailout.

 

 

Among other effects also to be watched include the impact on upcoming elections. The electorate is worried, uneasy, and will likely exhibit reactions across a wide spectrum. While the members of Congress may feel they had no choice with regard to the bailout bill, there may still be considerable voter backlash.

 

Amidst all of the tumult over the Fed bailout and the Presidential debates, not to mention a host of other events large and small, news about WaMu’s collapse has already slipped from the front pages of the nation’s newspapers. Astonishingly, in one short weekend, events have superseded the largest bank failure in U.S. history.

 

The problem with treating this extraordinary development as just another item in the news cycle is that it could be possible, notwithstanding the magnitude of the event, to overlook its significance. Make no mistake, however; the consequences of Washington Mutual’s failure, and the specific way the J.P. Morgan buyout went down, are enormously significant, and the implications of these developments are laden with portent.

 

Takeover/Buyout/Bankruptcy

On September 25, 2008, the Office of Thrift Supervision announced (here) that it closed Washington Mutual and appointed the FDIC as the institution’s received. The FDIC announced that same day (here) that as a result of an auction process J.P. Morgan Chase had acquired Washington Mutual’s banking assets.

 

J.P. Morgan’s September 25, 2008 press release (here) provides further detail regarding this transaction. J.P. Morgan’s press release explains that in exchange for the payment of $1.9 billion, the company had acquired "all deposits, assets, and certain liabilities of Washington Mutual’s banking operations." The press release also states that the transaction excluded "senior unsecured debt, subordinated debt, and preferred stock" of WaMu’s banks as well as any assets or liabilities of the parent holding company or the parent holding company’s nonbank subsidiaries.

 

J.P. Morgan also announced that as a result of this acquisition, it "will be marking down the acquired loan portfolio by approximately $31 billion," which it said "represents our estimate of remaining credit losses related to the impaired loans."

 

The final step of this process followed on September 26, 2008, when the parent holding company filed a bankruptcy petition in U.S. Bankruptcy Court in Delaware, about which refer here.

 

As NYU economics professor Lawrence White noted in a September 26, 2008 Forbes column (here), for its $1.9 billion investment, J.P. Morgan acquires net assets with a nominal value of $240 billion and deposit liabilities of $188 billion, suggesting a nominal acquisition value of approximately $52 billion. Of course, the planned write-downs diminish –but do not eliminate –this nominal value. Nevertheless J.P Morgan’s $1.9 billion offer was the best bid that the FDIC received.

 

Clearly, asset valuation uncertainty explains this apparent disparity. J.P. Morgan’s announcement of an immediate $31 billion write-down underscores the magnitude of the valuation uncertainty. But both the extent of this disparity and the magnitude of the write-downs have major implications, as discussed below.

 

One aspect of J.P. Morgan’s acquisition that was widely emphasized in the press reports was the FDIC’s success in completing this transaction without any losses to the deposit insurance fund. Indeed, there were reports that the FDIC’s chairman’s highest priority in the sequence of events was protecting the fund. Had the deposit insurance been called into play, the impact on the fund would have been enormous, and impact on depositors whose deposits exceeded the insurance limits also would have been significant. Nevertheless, the particular way in which the fund was protected, which left debtholders and bond investors exposed, presents its own set of issues.

 

Consequences and Implications

1. Valuation Issues: The massive discount on WaMu’s asset valuations implied in J.P. Morgan’s acquisition price has great significance for other institutions holding similar assets. While mortgage assets are not uniform, and the distinct characteristics are highly relevant to valuation issues, the obvious implication of the price and of J.P. Morgan’s announced $31 billion write-down is that similar assets on other institutions’ balance sheets may be overvalued.

 

Professor White, in the Forbes article cited above, states that these developments are "strong reinforcement for the view that lots of other institutions’ mortgages and mortgage-backed securities are also overvalued."

 

Indeed, the September 27, 2008 "Heard on the Street" column in the Wall Street Journal notes that "applying J.P. Morgan’s projections on other large banks implies higher losses for those with WaMu-like assets." The Journal column specifically suggests that these concerns may explain why Wachovia’s shares plunged on Friday and that rumors of Wachovia’s possible sale also immediately began circulating. Wachovia, it should be noted, like WaMu, has a significant concentration in Option ARM loans, which undoubtedly reinforce the concerns about possible future write-downs on Wachovia’s loan portfolio.

 

Professor White notes with respect to these valuation concerns that "most of these assets are held outside the banking system," as they are held in "investment banking firms, finance companies, insurance companies, hedge funds, mutual funds, pension funds, etc." All of these institutions will face valuation pressures in the wake of the WaMu takeover.

 

In any event, along with the possibility that other institutions’ assets may be overvalued is the consequent possibility that investors in those institutions may later claim that they have been misled about the true financial condition of those institutions. (Indeed, WaMu itself previously had been hit with a securities lawsuit in which investors claim that they were misled about the company’s exposure to Option ARM loans, as noted here.) All of which may suggest the possibility of significant additional litigation, as discussed further below.

 

2. The Insurance Fund is Safe. Bond Investors? Not So Much: J.P. Morgan’s September 25 press release carefully isolated the liabilities it was not acquiring as part of the transaction. While the company cheerfully acquired WaMu’s bank deposit liabilities, other liabilities were left behind.

 

As detailed in a September 25, 2008 Seattle Times article (here), J.P. Morgan’s $1.9 billion payment will go into a fund for WaMu’s creditors. The only creditors likely to get anything out of the fund are the holders of WaMu’s $7 billion senior unsecured debt, who possible will get not more than 27 cents on the dollar. Holders of over $11 billion of WaMu subordinated debt and preferred stock will get nothing, as will other WaMu debtholders. The total amount of WaMu’s debt outstanding may be as much as $28 billion.

 

Among others that will be left out in the cold is the private equity fund TPG (formerly known as the Texas Pacific Group), which pumped $1.3 billion into WaMu as one of several investors that invested $7 billion into WaMu just five months ago. As the Wall Street Journal noted in its September 27, 2008 article entitled "WaMu Fall Crushes TPG" (here), these "losses illustrate the peril of investing in distressed banks and financial companies."

 

These losses are significant in two particular ways. First, WaMu’s collapse has thrown off significant losses for bond investors, many of whom are already reeling from earlier collapses of Bear Stearns, Lehman Brothers, Fannie Mae and Freddie Mac. As these losses continue to filter out into the investment community and the larger economy, the cumulative effect potentially could be staggering (especially in combination with equity investment losses, discussed below).

 

These losses may also have important implications for other troubled banks’ capital raising prospects. The FDIC may well have succeeded in protecting the insurance fund in this instance. However, the incentives for any investors to consider pumping additional capital into banking institutions have been undermined. Certainly, the likelihood of another TPG-like capital infusion for another troubled bank would seem increasingly improbable in light of these developments.

 

By its unwillingness to liquidate WaMu now, a move that might have salvaged something for bond investors, the FDIC potentially could have set up further problems down the road. If investors are unwilling to risk investments in floundering financial institutions, additional bank failures could follow. The losses to the insurance fund potentially could be even greater.

 

3. "I awoke last night to the sound of thunder/ How far off I sat and wondered": The reverberations from the WaMu collapse will ripple through the economy, with many effects near and far, for months to come. Some, like the ones described above, may be readily apparent. Others will be more remote and will take longer to emerge.

 

Take, for example, the recondite world of collateralized debt obligations, already the subject of much scrutiny due to CDO investment in subprime mortgages. According to a September 26, 2008 Bloomberg article (here), WaMu’s collapse could also have a "significant" impact on CDOs.
 

According to the Bloomberg article, 1,526 synthetic CDOs sold default protection on WaMu. The CDOs sold notes to investors that are repaid using proceeds of credit default swap premiums. As a credit default swap seller, the CDOs must pay the buyers face value in exchange for the underlying securities or the cash equivalent after a bankruptcy filing.

 

In other words, as a result of WaMu’s collapse, the CDOs are likely to sustain enormous losses. CDO investors and noteholders, whose investments were already hit by the Lehman Brothers bankruptcy, will see the value of their investments fall even further.

 

The realization and assessment of these and other more remote consequences of WaMu’s failure, as well as other tumultuous events in the financial marketplace, may take time to emerge. It will likely be a considerable time before all of these consequences have surfaced.

 

4. A Billion Here, A Billion There: In the last year, WaMu’s market capitalization declined over $80 billion. In isolation, this is significant. Taken collectively with other market losses, the aggregate impact is staggering. Collectively, the failures of WaMu, Lehman Brothers, Bear Stearns, Fannie Mae and Freddie Mac represent roughly a $230 billion loss in market capitalization from a year ago.

 

Nor is that all. If you add in the market capitalization loss in the last year at AIG, Merrill Lynch, Goldman Sachs, Bank of American and Citigroup, the aggregate market capitalization decline in the last year is nearly $700 billion (just about the size of the Treasury bailout, by coincidence).

 

These stocks were largely held by institutional investors. The aggregate losses on these investments significantly affect the value of these institutions’ holdings, with significant implications for these institutions’ beneficiaries, investors and other stakeholders.

 

5. Knock-on Effects: One consequence of these circumstances in our blame-centric culture is that as these losses surface and become more apparent, litigation seems virtually inevitable. I have already noted (here and here) how Lehman Brothers’ failure has been significant factor in recent litigation against other companies. Similar litigation consequences from WaMu’s collapse seem likely. The wide dispersion of the consequences from WaMu’s failure raises the significant possibility that the litigation effects will not be limited to the financial sector alone.

 

Commercial Irony: Although ironic now with the benefit of hindsight, Washington Mutual consciously built its identity on its willingness to lend to those unable to borrow from others. The thrift built this identity with a series of commercials that remain amusing, although for some reasons now perhaps different than at the time the commercials were first created. I have linked a particularly amusing example below, which I commend for its entertainment value. (Hat tip to the Wall Street Fighter blog, here, for the video link.) Note the ironic symbolism of the disfavored borrower popping a balloon at the start of the commercial.

 

https://youtube.com/watch?v=laot_Eomr3s%26hl%3Den%26fs%3D1

In my preceding post, I wrote about a possible new wave of credit crisis lawsuits, where the defendant companies are not themselves directly affected by credit crisis fallout, but instead suffer from exposure to other companies that have been directly affected. In a litigation example of these circumstances at work, plaintiffs’ lawyers today initiated another securities class action against a company suffering the effects of Lehman Brothers’ collapse.

In a September 22, 2008 press release (here), plaintiffs’ lawyers announced their filing in the Southern District of New York of a securities class action lawsuit against Constellation Energy Group and certain of its directors and officers. A copy of the complaint can be found here.

 

According to the press release, the complaint alleges that

 

In July 2008, the Company reported favorable financial results and reaffirmed EPS guidance of 5.75 per share for 2008. In August 2008, analysts questioned Constellation’s accounting and the implications of a credit downgrade. Then, on September 15, 2008, investors and the market became aware of Constellation’s exposure to Lehman Brothers Holdings Inc.’s (“Lehman”) bankruptcy, which affected the Company’s ability to engage in energy-related trades. With this news, Constellation’s shares plunged to $47.99, a 50% drop from the Company’s Class Period high of $97.34 per share.

 

The complaint specifically alleges that: 

(a) defendants were inflating Constellation’s results through manipulations relating to the characterization of depreciation expense which inflated the Company’s reported cash flows; (b) the Company’s financial results were inflated by overly optimistic assumptions which were reflected in mark-to-market accounting; (c) the Company’s exposure to credit problems of trading partners was much greater than represented – in fact, one of Constellation’s key trading partners, Lehman, was having severe financial problems; and (d) the Company was not on track to report 2008 EPS of $5.25+ per share.

This lawsuit raises a number of different allegations against the defendants, and the allegations relating to Lehman’s collapse are only part of this lawsuit. Nevertheless, this lawsuit demonstrates that the reverberations from the most recent phase of the credit crisis are spreading far beyond the high profile financial services companies whose names have dominated recent headlines. As Constellation’s circumstances show, the financial companies’ turmoil has also affected their “trading partners,” adding to their partners’ difficulties, and, at least in the case of Constellation, leading to litigation.

 

One of the questions I have long been asking about the subprime and credit crisis litigation wave is whether it will eventually spread beyond the financial sector. There may not yet be quite enough evidence to declare that the wave has done so. But the allegations against Constellation, and the fact that a company like Constellation has been sued, does suggest the way the litigation wave could well spread outside the financial sector, if it eventually does in any numerically significant way.

 

In my previous post, I described this potential new class of credit crisis litigation as representing the “second derivative” of the credit crisis litigation wave – that is, the companies targeted may not themselves have been directly affected by the credit crisis, but other companies to which they are exposed have been directly affected, as a result of which even the company seemingly remote from the direct credit crisis turbulence winds up experiencing and suffering from its effects.

 

It remains to be seen whether this new wave of credit crisis litigation becomes widespread. The one thing I know for sure is that the consequences from last week’s event are enormous and are continuing to ripple through the financial markets and the entire economy. Many companies are likely to be affected and some will be sued.

 

Some readers may recall that Constellation was also in the news last week in connection with the announcement that Constellation is to be acquired by Berkshire Hathaway affiliate company MidAmerican Energy. Indeed, MidAmerican has agreed to buy Constellation in a transaction valued at about $4.7 billion (refer here). Investors’ reaction to this transaction may be assessed from the per share acquisition price of $26.50, which is less than half the company’s market value just a week previously. At latest word (refer here), a competing bidder is weighing an alternative bid despite the fact that Buffett’s company has already injected $1 billion in cash into Constellation.

 

Ripple in Still Waters: In another illustration of the wide dispersion of the economic consequences from the large financial institutions’ failures, the September 23, 2008 Wall Street Journal reports in an article entitled “Fannie Mae, Freddie Mac Takeovers Cost U.S. Banks Billions” (here), that about a quarter of the nation’s banks lost a combined $10 to $15 billion due to the mortgage giants’ government takeover.

 

According to the Journal, the American Bankers Association reports that approximately 2300 banks hold Fannie and Freddie preferred shares, which are likely worthless. 85% of the affected institutions are community banks with assets less than $1 billion. The irony is that many of these banks themselves steered clear of subprime lending excesses, and at the same time considered Fannie and Freddie, as the Journal states, “rock solid investments.”

 

For most of the affected banks, the losses will be small and manageable. Nevertheless, the dispersion of the losses shows how widespread are the effects from recent events. The impact on companies that were not themselves directly involved in subprime lending illustrates the way these consequence are spreading the effects of the credit crisis to the larger economy.

 

The economic crisis that began as the subprime meltdown has clearly entered a dark new phase. And just as the prior stages of the crisis generated waves of related litigation, this new phase already has produced its own distinctive round of lawsuits. Like the underlying economic circumstances, the new litigation phase also seems darker and more threatening.

 

As might have been predicted, shareholder lawsuits have already been filed against the directors and officers of some of the most prominent companies caught up in the recent events. For example, on September 15, 2008, Merrill Lynch shareholders filed a complaint (here) in New York state court against the company and certain of its directors and officers alleging that the company’s planned merger with Bank of America is the result of a "flawed process and unconscionable agreement" and that the defendants had breached their fiduciary duties.

 

Similarly, as reported on September 18, 2008 in CFO.com (here), shareholders have filed a Delaware Chancery Court lawsuit against certain current and former directors and officers of AIG. The lawsuit blames the defendants for the company’s "exposure to and grossly imprudent risk taking in the subprime lending market and derivative instruments." The lawsuit seeks the return to AIG of all compensation paid to AIG’s CEO and to its directors, among other things.

 

These lawsuits are perhaps the almost inevitable products of events reported in last week’s headlines. But along with these more predictable litigation consequences, there have also been additional developments and resulting litigation, and it is this further litigation that suggests that the credit crisis litigation wave my now have entered a new, more complex phase.

 

As widely reported last week, the Primary Fund money market fund of the Reserve Family of Funds "broke the buck" when its "net asset value" fell below one dollar a share. Reserve’s September 16, 2008 press release announcing that net asset value of the Primary Fund had fallen below one dollar can be found here. On September 18, 2008, plaintiffs’ counsel filed a securities class action lawsuit in the Southern District of New York (complaint here), on behalf of persons who purchased shares of the Primary Fund between September 28, 2007 and September 16, 2008, against the Fund’s underwriters, investment advisor, and officers and directors.

 

The complaint alleges that the Fund’s offering documents failed to disclose, among other things, "the lack of diversification of the Fund’s assets and exposure to, at a minimum, now largely worthless debt securities valued at $785 million of the now defunct Lehman Brothers Holdings, Inc."

 

The circumstances behind this lawsuit represent something of a second derivative of the subprime crisis. That is, the subprime meltdown led to problems with certain real estate assets and investments of Lehman Brothers, which ultimately led to Lehman’s collapse, which caused its debt securities to lose substantially all their value, which undermined the asset value of the Primary Fund and harmed its investors.

 

The reverberations of these second derivatives of the subprime meltdown are rippling through the economy, encompassing a broader array of participants, many of whom may have had little or no direct exposure to subprime-prime related investments per se. However, these companies had exposures to other companies that had exposures to mortgage backed assets.

 

The Primary Fund is far from the only market participant that has been harmed by its exposure to losses during this latest phase of the economic cycle. By way of illustration, on September 16, 2008, Conseco announced (here) that as of that date it held $108 million of securities of Lehman Brothers, AIG, and Washington Mutual, and that the company had during the third quarter realized losses of approximately $40 million on sales of securities of these issuers. Conseco’s shares fell over 40% the next trading day, although the share price has subsequently recovered somewhat.

 

Similarly, Japanese insurers have disclosed a combined $2.4 billion of potential losses from Lehman’s collapse (refer here).

 

On September 11, 2008, Progressive Corporation announced (here) August 2008 write-downs of $324 million (of which $278 million related to common and preferred stock investments in Fannie Mae and Freddie Mac), and also disclosed that the U.S. government’s take over of the companies produced an additional $171 million of September 2008 losses, bringing Progressive’s combined two month investment write-downs on its Fannie and Freddie holdings to nearly a half a billion dollars – a substantial amount even for a company with $20 billion in assets.

 

A multitude of other companies have announced or will be announced similar losses, and not just related to Lehman, but also in connection with Fannie Mae, Freddie Mac, AIG, and other companies whose securities have faced or that will face similar collapses. A September 18, 2008 CFO.com article entitled "Exposed and Disclosed: Filings Show Ties to Turmoil" (here) highlights recent filing in which companies have disclosed their exposure to investment declines as a result of adverse developments at these companies. A September 16, 2008 CFO.com article similarly identifying companies disclosing losses from the Lehman bankruptcy can be found here.

 

The losses on these investments are widespread and will affect a wide variety of market participants. The heroic (and astronomically expensive) bailout package that the Treasury department announced over the weekend (refer here) will not restore the value of these investments. In the weeks and months ahead, many other entities will be reporting losses or write-downs on these and other investments. In addition, in a completely different aspect of the current crisis, market participants who depended on Lehman for credit default protection will also be reporting the consequences of Lehman’s demise.

 

These announcements undoubtedly will trigger strong investor reactions for at least some of the disclosing companies, as was the case, for example, in connection with Conseco’s recent announcement. And in some instances, as was the case in connection with the Primary Fund, these announcements will also result in litigation.

 

Several months ago, I noted that the evolving litigation wave had long ago ceased to be just about the subprime meltdown. As lawsuits emerge from what I described above as the second derivative of the subprime meltdown, where companies lacking any direct exposure to subprime nevertheless experience losses because of exposure to other companies suffering credit crisis-related reversals, the ensuing litigation wave could threaten to become a generalized inundation deluging a substantial number of participants in the larger economy.

 

The ultimate wildcard is the impact that the current comprehesive Treasury bailout will have on litigation going forward. The analytic model for the current bailout plan is the formation of a government salvage operator along the lines of the Resolution Trust Corporation (RTC) during the Savings & Loan crisis. Those of us who were around then will recall that the RTC was an active litigant aggressively using litigation to try to recover taxpayer losses. Law.com has a September 22, 2008 article entitled "U.S. Could Emerge as Major Player in Suits Stemming From Financial Crisis" (here) that speculates on that the new government bailout agency could once again play an active litigation role.

 

How the current bailout package ultimately will shake out remains to be seen. But one of the important themes in the current dynamic is the urge to assign blame. Some congressional figures have already targeted executive compensation and compensation clawbacks as important considerations of the bailout effort. These kinds of considerations could well lead to an effort to target directors and officers as well as their professional advisors, as part of the overall bailout.

 

More Reserve Fund Litigation: Shareholders have raised an additional concern in connection with the recent events involving the Reserve Fund. In a separate September 19, 2008 lawsuit (complaint here), Fund investors have also alleged that the Fund tipped off "about a dozen institutional investors" to withdraw a total of $40 billion from the funds at one dollar a share immediately before the Fund’s announcement of the losses due to the Lehman investment’s drove the net asset value below one dollar.

 

In a September 19 order (here), Judge Paul Magnuson entered a temporary restraining order prohibiting the Fund from honoring withdraw requests of over $10,000, until an evidentiary hearing can be held. Among other things, Judge Magnuson’s order said that "plaintiffs would be irreparably harmed if Defendants were allowed to honor redemption requests of investors who were made privy to the bad news before the public was made aware." The court will hold further hearings on September 23, 2008.

 

Special thanks to a loyal reader for providing copies of the insider tipping complaint and the TRO.

 

Run the Numbers: I have added the AIG bailout lawsuit and the Merrill Lynch/BoA lawsuit to my list of subprime and credit crisis-related derivative lawsuits, which can be accessed here. With the addition of these two lawsuits, the current tally of subprime and credit-crisis related derivative lawsuits now stands at 23.

 

In addition, I have added the Reserve Fund lawsuit, together with a more conventional subprime-related lawsuit filed last week against the Canadian Imperial Bank of Commerce (about which refer here) to my list of subprime and credit crisis-related securities lawsuits, which can be accessed here. With the addition of these two new securities lawsuits, the current tally of subprime and credit crisis-related securities lawsuits now stands at 117, of which 77 have been filed in 2008.

 

Storm Surge: Plaintiffs’ securities attorneys were extraordinarily busy this past week. By my unofficial count, there were at least nine new securities class action lawsuits filed in the past week alone. And while some of this activity is directly attributable to the economic circumstances discussed above, a part of the activity is less directly connected.

 

Indeed the past week’s new lawsuits involve a broad variety of companies including clothing companies (refer here), wireless communications companies (refer here and here) and silicon wafer manufacturers (refer here).

 

We clearly are well past the securities lawsuit filing lull that prevailed from mid-2005 through mid-2007. The more troubling question now is whether we have entered a dangerous new phase of heightened litigation activity that includes but also extends well beyond lawsuits arising directly from financial difficulties attributable to turbulence in the credit markets.