In what is as far as I am aware the first class action settlement in the current wave of subprime-related securities lawsuits, on October 14, 2008, WSB Financial Group announced (here) that it had entered into a settlement agreement of the class action lawsuit pending against the company and certain of its directors and officers.

 

 

As detailed in greater length here, on October 30, 2007, plaintiffs’ lawyers’ had initiated a securities class action lawsuit in the Western District of Washington. A copy of the plaintiffs’ consolidated complaint can be found here.

 

 

WSB Financial Group is the parent company of Westsound Bank. The lawsuit alleged that the offering documents associated with the company’s December 21, 2006 IPO contained material misrepresentations or omissions. Among other things, the complaint alleges that the offering documents stated that the company “focused on originating and maintaining a high-quality loan portfolio and had rigid underwriting policiesdesigned to ensure the credit quality of the Company’s portfolio. In reality, however, WSB Financial originated hundreds of high-risk loans in violation of the Company’s stated policies for a total amount of at least $90 million.”

 

 

In its October 14 press release, the company stated that the parties had agreed to a settlement of $4.85 million. The press release also states that the company’s D&O insurance policy would contribute $4.45 million toward the settlement and had previously contributed approximately $350,000 toward the cost of the settlement. The proposed settlement is subject to court approval.

 

 

As a relatively small settlement of one of the smaller, lower profile cases in the current litigation wave, this settlement is likely to have relatively little direct influence on other pending cases. The significance of this settlement may simply be that it has happened at all. With so many of the subprime and credit crisis-related cases only in their earliest stages, the likelihood of settlements emerging seemed like a distant prospect. It may yet be a considerable time before the higher profile cases move toward the settlement stage, even assuming they survive preliminary motions. This settlement suggests that at least some cases will move more quickly toward resolution.

 

 

Nevertheless, anyone who thinks that the current litigation morass might quickly be cleaned up may need to curb their enthusiasm. An October 13, 2008 Law.com article entitled “New Wave of Class Actions Filed in Wake of Subprime Collapse” (here) quotes a plaintiffs’ securities class action attorney as saying that he anticipates that subprime litigation “will keep us busy for seven or eight years.”

 

 

In any event, I have added the WSB settlement to my table of subprime and credit-crisis related case dispositions, which can be accessed here.

 

 

A Different Approach: In our country, the most important issue in any crisis is figuring out who to blame. Refined distinctions are not a necessary part of this blame assignment process, and blame can be assigned indiscriminately. (If you doubt this assertion, please refer to the public statements of any U.S. politician during the current financial turmoil.) Our transatlantic cousins apparently take a different approach, which I must say has much to recommend it.

 

 

According to an October 14, 2008 Law.com article (here), the nationalized British lender Northern Rock has announced that it will not bring legal action against its former directors and officers, after having concluded that "there are insufficient grounds to proceed with a negligence action against the ex-directors." The article also reports that "the bank’s auditors are off the hook."

 

When, as has been the case recently, there is a single predominant story, there also is a danger that other important developments may be overlooked. The subprime and credit crisis meltdown and related litigation has been so preoccupying that almost nothing else has broken through the noise.

 

However, a recent casual observation made me go back and take a closer look at latest securities class action lawsuit filings. I was surprised to observe that, at least by one measure, a majority of recent filings are unrelated to the credit crisis.

 

What initially caught my eye was the recent flurry of litigation filing activity involving life sciences companies. Just since September 23, 2008, four life sciences companies have been sued in securities class action lawsuits:

 

1. Spectranetics: On September 23, 2008, plaintiffs’ lawyers initiated a securities class action lawsuit in the District of Colorado against Spectranetics, a medical device manufacturer, and certain of its directors and officers. As reflected more fully here, shareholders filed the suit after the company’s stock price declined following publicity relating to the company’s alleged involvement in customs’ law violations.

 

2. Medicis Pharmaceuticals: On October 3, 2008, plaintiffs’ lawyers filed a securities class action lawsuit in the District of Arizona against Medicis Pharmaceuticals, a specialty pharmaceutical company, and certain of its directors and officers. As described here, the lawsuit followed the company’s announcement that it would be restating its annual and quarterly financial statements for the period 2003 through 2007, due to the company’s sales return reserve calculation.

 

3. Biovail: On October 8, 2008, plaintiffs’ lawyers announced that they had filed a securities class action lawsuit against Biovail, a specialty pharmaceutical company, and certain of its directors and officers, following disclosures of issues involving one of the company’s developmental stage drugs. The plaintiffs’ lawyers’ October 8 press release can be found here.

 

4. Elan Corp.:  On October 14, 2008, plaintiffs’ lawyers initiated a securities class action lawsuit in the Southern District of New York against Irish biopharmaceutical company Elan Corp. and certain of its directors and officers alleging that the company failed to disclose unfavorable results in Phase II clinical trials of a compount the company is developing to be used to treat patients suffering from Alzheimer’s disease. A copy of the plaintiffs’ lawyers’ October 14 press release can be found here.

 

 

Obviously, none of these lawsuits has anything directly to do with the turmoil in the financial markets that has been dominating the headlines. Nor are these cases the only securities lawsuits filed in recent weeks that are unrelated to the financial meltdown.

 

A review of the securities lawsuit filings during September 2008 reveals that a majority – 14 out of 24 – of the September filings were not directly related to the credit crisis. Moreover, the case filings spread across a wide variety of kinds of companies, including children’s apparel (Carter’s, about which refer here), gas exploration and development companies (Quest, refer here) and computer graphics, (NVDIA, refer here).

 

There was a flurry of activity in September involving companies in the wireless industry. The September filings included lawsuits against wireless broadband companies NextWave Wireless (refer here) and Novatel Wireless (refer here), and a wireless network management software company, Harris Stratex (refer here).

 

But whether or not there is any significance to this flurry of lawsuits involving companies in the wireless industry, or to the flurry of lawsuits noted above involving life sciences companies, the most noteworthy point is that these lawsuits are not related to the credit crisis, and that many of the other recent filings similarly are unrelated to the credit crisis.

 

There is no doubt that the most significant factor in the overall increase in securities litigation activity in recent months has been the subprime and credit crisis related litigation. But merely because this litigation has been the most important factor does not mean that it is the only factor. There has been a significant amount of securities litigation activity unrelated to the subprime meltdown and the credit crisis. Focusing exclusively on the credit crisis-related litigation could result in overlooking the other important securities lawsuit filing developments.

 

Although the plaintiffs’ lawyers have been quick to pursue claims from the credit crisis, they have not done so to the exclusion of all other activities. Indeed, the plaintiffs’ bar continues to pursue other kinds of claims, and so merely because a company has not been directly affected by the credit crisis does not by itself mean that the company is free from securities litigation exposure in the current environment.

 

A Note About Lawsuit Counts: There are two cases that complicate how the September 2008 filings are categorized. As I have previously noted (here and here), the lawsuit filings involving The Reserve Group and Constellation Energy do not directly arise out of the subprime meltdown or credit crisis. However, as explained more fully in my prior posts, these cases arguably represent a "second derivative" of the credit crisis.

 

At the same time, it should be noted that the Stanford Law School Securities Class Action Clearinghouse, employing a strict definition, did not categorize these two cases as subprime related. I have noted on this blog in the past the difficulties involved with "counting" these lawsuits as the subprime litigation wave has evolved. But, in any event, the statement above that the majority of September securities lawsuit filings were not related to the credit crisis, uses the Stanford website’s categorization, which I suspect also reflects a more common understanding.

 

A Final Note: The essential thrust of this blog post depends on the assumption that the distinction between cases that are and are not credit crisis-related is readily apparent. However, as the credit crisis becomes more generalized and if there is a significant downturn in the larger economy, there may be an eventual convergence of the two categories, as all companies become subject to the general downturn.

 

If the entire economy is suffering the effects of the unavailability of credit, the litigation that follows may no longer be susceptible to the categorization I have been trying to maintain. The possibility of this development is one more reason to maintain a broader perspective across all of the ongoing litigation activity.

 

Déjà vu All Over Again: Biovail, a Canadian corporation, is no stranger to U.S.-style securities class action litigation. As reflected here, the company was the target of a 2003 securities class action lawsuit that ultimately settled for $138 million. The settlement was just finalized on August 8, 2008, exactly three months before the filing of the most recent securities lawsuit against the company. (UPDATE: As a result of the reader comment, I relaize the prior sentence should say that the new lawsuit was exactly TWO months to the day from the finalization of the prior dismissal. I stand corrected!)

Similarly, Elan, a company domiciled in Ireland, has been the target of two previous securities class action lawsuits, refer here and here.

 

After the close of business on Friday, October 10, 2008, the FDIC announced (here and here) that state regulators had closed two banks, Meridian Bank of Eldred, Illinois, and Main Street Bank of Northville, Michigan. The closure of these two banks brings the 2008 total number of bank closures to 15.

 

By way of comparison, there were only three bank closured during all of 2007. Indeed, there were none at all between June 25, 2004 and February 2, 2007. (An FDIC table showing all bank closures since 2000 can be found here.) According to an October 11, 2008 Bloomberg article (here), the 15 bank closures during 2008 already represents the highest annual total since 1993, which of course was the tail end of the last era of failed banks.

 

Nor is this current wave of bank failures over. Conditions in the housing market continue to deteriorate, and job losses associated with the anticipated recession could only accelerate this process. A slumping economy will challenge borrowers across all lines of credit. This June 30, 2008 FDIC chart (here) graphically illustrates the dramatic growth in troubled loans over recent periods, and both trendlines and headlines suggest that this will only continue.

 

Moreover, the balance sheets of many banks are already under pressure because of the banks’ extensive holdings in securities of Fannie Mae and Freddie Mac, and, to a lesser extent, Washington Mutual, AIG, and Lehman Brothers. Banks dependent on short term interbank loans may also be experiencing liquidity issues as a result of the current disruption in the credit markets.

 

As of the end of the second quarter 2008, the FDIC listed (refer here) 117 banks on its "Problem List," which represents a 30 percent jump since the end of the first quarter. The "Problem List" numbers through the end of the third quarter are not yet available, but significant further deterioration seem probable given third quarter events, and developments already in the first two weeks of the fourth quarter certainly have not helped.

 

UPDATE: Consistent the hyperspeed circumstances that have come to characterize recent events, the announcement this evening after the close of the market that the U.S. will buy stakes in the Nation’s largest banks (refer to WSJ article here), along with related disclosures, potentially impacts the foregoing analysis as well as much that follows. In particular, the Journal is reporting that "one central plank of these new efforts is a plan for the Treasury to take approximately $250 billion in equity stakes in potentially thousands of banks." This obviously could impact the issue whether or not or to what extent other banks will fail. As these details are only now emerging (after I wrote this entire blog post, wouldn’t you know it), and as it will take some time before the details become clear, much less that the government acts, the discussion in this post may remain relevant. How relevant remains to be seen, depending on the specifics of the government’s plan and its implementation.

 

A significant part of the last era of failed banks was the appearance of a flotilla of lawsuits, in which investors and regulators sought to assign blame and recover losses. There already has been extensive litigation filed in connection with the two most prominent bank failures of 2008, IndyMac (refer here and here) and Washington Mutual (refer here).

 

The follow-on failed bank litigation has started to emerge in connection even with the lower profile failures, as illustrated by the recent lawsuit filed in connection with the failure of Integrity Bank of Alphretta, Ga.

 

State banking regulators closed Integrity on August 29, 2008, and the FDIC was appointed as its receiver (about which refer here). The bank’s deposit liabilities and some of its assets were sold to Regions Financial Corp. Prior to a March 2008 delisting, shares of Integrity’s holding company, Integrity Bancshares, traded on Nasdaq.

 

On September 12, 2008, Integrity shareholders filed a purported class action in Georgia (Fulton County) Superior Court against the holding company and four Integrity officers. On October 7, 2008, the defendants removed the case to the Northern District of Georgia. A copy of the removal petition, to which the state court complaint is attached, can be found here.

 

The plaintiffs’ complaint alleges that the defendants misled investors about the bank holding company’s health during 2006 and 2007, as a result of which the plaintiffs allege violation of state securities laws, common law fraud, and negligent misrepresentation. The complaint specifically alleges that the defendants understated or failed to disclose "the nature and degree of risk associated with the following conditions":

 

(i) a loan portfolio comprised almost entirely on real estate acquisition, development and construction, which risk was further by an unreasonable concentration of such toasts its borrower relationship (the "Related Loans"), (ii) a loan portfolio principally collateralized by real estate, (iii) operating with a Board of Directors that failed to provide adequate supervision over and direction to Bank management (iv) operating with inadequate management not sufficiently experienced in or Knowledgeable of good lending practices, (v) operating with inadequate equity capital and reserves in relation to the volume and quality of assets held by the operating with a large volume of poor quality loans, (vii) operating with inadequate allowance for loan and lease basses, (viii) operating with hazardous loan and administration practices, (ix) banking regulations concerning safe lending practices, (x) the potential for cross-defaults with respect to some or all of the Related Loans, (xi) potential difficulty in and realizing on loan collateral in market conditions, (xii) the potential and severity of losses from deteriorating market affecting borrowers, and (xiii) the adverse affect of losses from such loan defaults on the Bank’s liquidity, capital resources and operations.

 

The Integrity lawsuit is not the only complaint to be filed in connection with the current wave of bank failures. In addition to the Washington Mutual and IndyMac lawsuits cited above, investors also filed a securities class action lawsuit in connection with the failure of NetBank, about which refer here. The FDIC’s press release about the September 28, 2007 closure of NetBank, which coincidentally was also based in Alphretta, Georgia, can be found here.

 

The failure of additional banks, while not inevitable, seems more likely than not. (I doubt there are many informed observers now who would assert that there will be no further bank failures.) To the extent more banks fail, there undoubtedly will also be further related litigation. And to the extent the pace of bank closures quickens, which certainly is within the range of possibilities, there could be a surge of "dead bank" litigation comparable to the flood of lawsuits that kept so many lawyers employed during the late 80s and early 90s (including, it should be noted, your humble correspondent).

 

If the earlier era is any guide, the lawsuits that may arise will include not just investor lawsuits like the one involving Integrity, but also actions by regulators as well. And again, if the earlier era is any guide, the defendants will include not only the financial institutions’ directors and officers, but also the financial institutions’ outside professionals, particularly the auditors and attorneys.

 

During the competitive D&O insurance marketplace conditions that have prevailed in recent years, many financial institutions were able to procure D&O insurance policies without a so-called regulatory exclusion (for further background about which refer here). It may be that in light of current conditions in the banking industry, the regulatory exclusion could be poised for a comeback.

 

In any event, community banks and other small to medium-sized banks, which have enjoyed a competitive D&O insurance marketplace for several years may now face rapidly changing and less advantageous conditions. Certainly, the D&O insurance underwriters will undoubtedly approach these kinds of accounts with a great deal more caution than in recent years.

 

Special thanks to Adam Savett of the Securities Litigation Watch blog (here) for providing a copy of the Integrity removal petition.

 

That Goes for Subordinated Investors Too:  In a prior post, here, I suggested that the dramatic failure of several prominent companies was drawing preferred shareholders into securities class action litigation. It appears that these events may be having the same effect on investors in subordinated securities as well.

 

According to the plaintiffs’ October 10, 2008 press release (here), a purported class action lawsuit has been filed in the Southern District of New York on behalf of person who purchased securities in the December 11, 2007 offering of 7.70% Series A5 Junior Subordinated Debentures of AIG, against certain AIG directors and officers, as well as the offering underwriters. The complaint alleges that the offering documents did not accurately represent AIG’s financial condition, and in particular misrepresented the company’s exposure to loss associated with credit default swaps.

 

As I noted in my earlier post, the massive investment losses associated with the collapse of these prominent financial companies is drawing many new classes of litigants who previously would not have become involved in securities litigation.

 

Run the Numbers: With the addition of the Integrity and the AIG subordinated debenture lawsuits, my current tally of the subprime and credit crisis-related securities lawsuits now stands at 124, of which 84 have been filed in 2008. The lawsuit tally can be accessed here.

 

When They Are Done in Reykjavik, Would They Be Willing to Come to Wall Street?: An October 13, 2008 Financial Times article entitled "Icelandic Women to Clean Up ‘Male Mess’" (here) reports that two women, Elín Sigfúsdóttir and Birna Einarsdóttir, are set to become chief executives of two nationalized banks the Icelandic government created in the wake of the recent banking crisis. A government official quoted in the ariticle said that these appointments were "an attempt to signal a new culture within the banking system"

The article quotes a banker who blames the Icelandic banking system’s collapse on "young and predominately male bankers" whose "eyes were bigger than their stomachs." A government official is quoted as saying that "now the women are taking over. It’s typical, the men make the mess and the women come in to clean it up."

Meanwhile, Iceland may run out of food, or at least imported food. Bloomberg reports (here) that due to the unwillingness of banks outside the country to trade in Iceland’s currency, the krona, the country’s foreign trade has come to a standstill. As a result, the country’s food shelves are being stripped bare, and they may not soon be replenished.

 

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.