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.

 

For many companies, one of the most challenging parts of the Directors and Officers (D&O) insurance procurement process is determining how much insurance to purchase. Against a backdrop of basic affordability, the company must consider complex issues such as limits adequacy – that is, how much insurance is enough?

 

Determining limits adequacy is even more challenging in light of today’s escalating claims severity. Recent developments underscore the fact that in addition to rising settlement levels, growing defense expense is an increasingly important part of the limits adequacy analysis.

 

 

In the September 2008 issue of InSights (here), I review recent D&O claims defense expense developments and consider their ramifications for purposes of both limits selection and insurance program structure. The article concludes with a brief review of claims management implications arising from these defense expense issues.

From the earliest days of the options backdating scandal, one of the recurring questions has been the potential extent of outside director liability exposure (refer, for example, here). On September 17, 2008, In a development that may also have significant implications for more recent events, the SEC filed settled options backdating-related charges against three former outside directors of Mercury Interactive.

 

A copy of the SEC’s September 17 press release regarding the settled charges can be found here. A copy of the Complaint can be found here.

 

 

The SEC’s complaint alleges that the three outside directors “recklessly approved backdated stock option grants, and reviewed and signed public filings that contained materially false and misleading disclosures about the company’s stock option grants and company expenses.”

The complaint alleges that the three individuals approved 21 backdated stock option grants between 1997 and April 2002. The complaint alleges that the three were aware that options with an exercise price lower than the date on which the options were actually approved created a compensation expense. Nevertheless, the complaint alleges, they repeatedly executed stock option documents while “failing to observe, among other things, that the exercise price of stock options they were approving was less than the market price of the company’s stock at the time of approval.”

 

 

The three individuals are alleged to have routinely signed unanimous consents “despite being presented with numerous facts and circumstances indicating that management was backdating option grants.” In addition to signing options grants made with earlier “as of” dates, on a few occasions the three “signed multiple written consents presented to them by management for the same grant with different grant dates that had more favorable prices.”

 

 

Without admitting or denying the allegations, the three agreed to permanent injunctions and each will pay a $100,000 financial penalty to settle the charges.

 

 

In light of the current circumstances, in which scapegoat hunting is in high gear, the SEC enforcement division’s statements about outside director liability may be instructive. SEC enforcement division director Linda Thomsen is quoted as saying, among other things, that “today’s action serves as further notice that misconduct by outside directors, as well as company management, will not be tolerated.”

 

 

Another enforcement division official is quoted as saying that, even though they understood how options expensing worked, “time and again, directors approved in-the-money option grants that had been backdated” and that the directors “recklessly approved option grants despite numerous facts and circumstances indicating to them that the grant dates they were approving were improperly backdated.”

 

 

While options backdating enforcement actions may seem like yesterday’s news (or even the day before yesterday’s news), these developments have significance today. If nothing else, they demonstrate the SEC’s willingness to pursue enforcement actions against outside directors, at least in certain circumstances, particularly if apparently knowing and active violations are involved.

These developments also underscore the continuing liability exposures to which outside directors potentially may be subject, and the need to address these exposures as part of any well-designed directors’ and officers’ liability insurance program. The SEC’s willingness to pursue outside directors for options backdating-related violations also suggests that today’s even more dramatic circumstances potentially could involve significant outside director liability exposure. The SEC’s interest in the possibility must be presumed.

 

 

Some readers may want to know what happened to the Mercury Interactive managers that proposed the backdating options for the directors’ approval. The SEC previously filed civil fraud charges against the company and four former officers (refer here). The company agreed to pay a $28 million penalty. The case against the former officers remains pending. A securities class action lawsuit arising from the Mercury Interactive options backdating allegations settled for $117.5 million (about which refer here).

 

UPDATE: The Race to the Bottom blog has an interesting post (here) discussing the SEC enforcement proceeding against Mercury Interactive’s outside directors. Professor Brown suggests that this case represents another instance where federal regulatory authorities may be creating federal standards of director conduct, in a gradual preemption of state law.

 

 

Despite Settlements, Auction Rate Lawsuit Proceeds: Following the recent high-profile auction rate securities settlements, one of the unanswered questions was what impact the settlements would have on the previously pending auction rate securities lawsuits. There are still no definitive answers. But, notwithstanding the settlements, at least one auction rate securities lawsuit is going forward.

 

 

As reported in the September 17, 2008 Wall Street Journal (here), Judge Gary Sharpe of the Northern District of New York has ruled that they auction rate securities lawsuits that Plug Power filed against UBS can go forward notwithstanding UBS’s recent $19 billion action rate securities buy-back settlement. A copy of the transcript of the September 17 hearing in the case can be found here. (Hat tip to the Wall Street Journal Law Blog, here, for the transcript link.)

 

 

According to Plug Power’s Amended Complaint (here), the company had alleged that, based on supposed assurances that the auction rate securities investments were safe and liquid, the company had bought $62.9 million in auction-rate securities backed by student loans. After the market for the securities seized up in February 2008, the company was (and remains) unable to liquidate its investments. The securities make up nearly half of the company’s investment portfolio.

Under the UBS auction rate settlements, institutional investors’ securities are expected to be bought back in 2010. The Journal quotes Plug Power’s attorney as saying that “we need the funds before 2010 and they’re not providing us a guarantee that they will be able to pay out.”

 

 

The disfavored position of institutional investors is one of the features of the auction rate securities settlements I noted at the time (refer here). Other institutional investors may be motivated similarly to Plug Power to proceed with litigation notwithstanding the buy back settlements. And the September 17 ruling in the Plug Power case suggests that at least some of the cases may go forward notwithstanding the settlements.

 

 

As noted in a September 18, 2008 post on the Securities Docket (here), plaintiffs’ attorney Daniel Girard of the Girard Gibbs law firm argues that private litigation still has a role to play in the auction rate securities debacle. He points out that many billions worth of these investments are not yet part of any settlement and that even with regard to the securities covered by the settlements, it will be a considerable time before the buybacks kick in (this in connection with investments that supposedly were liquid and just like cash.).

 

 

BAE Systems Lawsuit Dismissed: In prior posts discussing civil litigation arising out of corrupt practices investigations (for example, here) one of the cases to which I have frequently referred is the derivative lawsuit filed in the District of Columbia by shareholders of BAE Systems. (For background regarding the BAE Systems case, refer here and here).

 

 

In a September 11, 2008 opinion (here), Judge Rosemary Collyer dismissed the BAE Systems derivative lawsuit on the grounds that the plaintiff lacked standing to bring the lawsuit.

The court’s ruling, while narrow, is interesting. The court held that as a result of the “internal affairs doctrine,” the law of the United Kingdom (the country in which BAE Systems is incorporated) governs the case. Under U.K. law, beneficial owners of a company’s securities lack standing to sue derivatively.

 

 

The plaintiff in the derivative suit did not directly own BAE systems shares but rather owned American Depositary Receipts (ADRs) as a result of which its ownership is merely beneficial under U.K. law. Accordingly, the plaintiff lacks standing to sue derivatively under U.K. law, and the court granted the defendants’ motion to dismiss.

 

 

Even though the court’s holding is narrow, it is significant in at least one respect. That is, it underscores the numerous potential obstacles that any plaintiff will face in attempting to use U.S. courts to assert civil liability in connection wtih a foreign domiciled company’s allegedly corrupt activities. Notwithstanding these obstacles, however, I continue to believe that the threat of civil litigation arising from corrupt practices investigations remains significant.

 

 

As the Wall Street Journal noted in its September 12, 2008 article entitled “U.S., Other Nations Step Up Bribery Battle” (here), anticorruption enforcement activity is an increasingly important prosecutorial priority worldwide, in which cross-jurisdiction cooperation is an increasingly important factor. As prosecutorial activity affects an increasing number of companies, investor interest n recovering civil damages for alleged harm to companies from the allegedly corrupt practices will continue to grow.

 

 

Special thanks to a loyal reader for the link to the BAE Systems decision.

 

One of the most closely followed recent case developments in the D&O insurance arena is the ruling in the CNL Hotels & Resorts case that a Section 11 settlement did not represent covered loss under a D&O insurance policy. As I noted in a recent post (here), on August 18, 2008, the CNL Hotels & Resorts holding was affirmed by the Eleventh Circuit. These developments have occasioned a great deal of discussion and commentary in the D&O insurance community.

 

Among the more noteworthy commentary on this topic is the analysis of the well-known and widely respected D&O insurance coverage attorney, Joe Monteleone of the Tressler, Soderstrom, Maloney & Preiss law firm. Joe’s commentary appeared in his firm’s August 2008 Specialty Lines Advisory (here, at page 2). As always, I found Joe’s analysis interesting, but I also found that I disagreed with him on a portion of his analysis.

 

Because I thought an exchange of views on these topics would be useful and perhaps even entertaining, I approached Joe to determine his willingness to engage in a colloquy on this topic to be reproduced on this site. Joe agreed, and our exchange follows below. First, I have quoted a portion of Joe’s article, which is followed by my comments on his article. Joe’s rebuttal appears after my comments.

 

Joe’s Article (Extract):

In his commentary, Joe wrote the following with respect to the CNL Hotels & Resorts case (and cases with similar holdings): 

 

When you cover the entity for its Section 11 loss, you are in effect saying that your IPO was overpriced by perhaps tens of millions of dollars. While not saying that it is OK, what you are saying is we will let the insurer step in and pay that loss and the corporation can keep its ill-gotten gain. How is that any different than a company simply refusing to pay for goods it has ordered and then letting its insurer pay when it is sued for a breach of its contract to pay? Insurance may cover negligent and even reckless misconduct, but it should not cover crooked behavior.

  Kevin’s Comments:

 

In his article, Joe makes a number of valid and interesting points, particularly with respect to the history of these issues. However, underlying Joe’s legal analysis is a series of value judgments. It seems to me that these value judgments misapprehend several critical considerations. I have set out these critical considerations below. In doing so, I also recognize that courts may have disfavored several of my arguments; readers will judge for themselves whether it is legitimate for me to reference these judicially disfavored points here

 

The first important consideration is that while companies that are the target of Section 11 claims may be alleged to have made all sorts of misrepresentations or omissions, these allegations are virtually never put to the test of proof. The mere fact that plaintiffs allege that offering documents contained supposed misrepresentations does not mean that the offering proceeds were in fact "ill-gotten." These kinds of claims, like all claims, are compromised because of the burdens and expense of litigation and because few are willing to accept the risk of an adverse verdict.

 

Nor does the fact that substantial sums are paid to compromise these claims, in and of itself, mean that the defendants company’s IPO was overpriced, much less that the company engaged in "crooked behavior." These settlements take place after the company has experienced a significant stock price drop. Compromising claims in the context of significant market capitalization losses can prove costly, but entry into even a costly settlement is far different than a determination of culpability or wrongdoing.

 

But I have even deeper concerns beyond just the fact that a settlement does not in and of itself betoken that a company’s IPO was "overpriced" or that the company is improperly keeping "ill-gotten gains." The fact is that the use of heavily freighted words such as "ill-gotten" and "crooked" are fundamentally misplaced in connection with alleged corporate liability in a Section 11 claim.

 

Under well-established legal principles, corporations are said to be "strictly liable" under Section 11 for material misrepresentations and omissions in offering documents. There is no element of fraud or scienter required in a Section 11 claim, and indeed plaintiffs pleading claims under Section 11 now routinely state (as a means of averting onerous pleading requirements) that they are not alleging or averring fraud in relation to these claims. The point is that in general not even the plaintiffs asserting the claims against these companies allege that the companies engaged in "crooked behavior."

 

In his article, Joe concedes that insurance properly can be paid for behavior that is merely negligent or even for behavior that is reckless. How then is it appropriate to withhold insurance benefits from companies who can be found liable without any fault at all?
 

 

I know that the district court in the CNL Hotels & Resorts case said that the absence of fraud allegations in Section 11 claims represents "distinction without a difference." But the absence of allegations of knowing or reckless misconduct does matter, deeply. The use of acutely pejorative words – that are completely unwarranted given the strict liability standard for corporate liability under Section 11 — has the effect of demonizing the company and putting it the position of moral error. The danger is that it is easier to withhold insurance benefits from a "bad" company. The use of these morally freighted words not only inappropriately shapes the tone of the dialog but potentially enables an unjustified result.

 

Moreover, even if a Section 11 claimant should allege fraud or dishonesty, the typical D&O policy’s fraud exclusion ensures that insurers do not have to pay benefits for "crooked behavior." But here’s the thing about the fraud exclusion – at least as worded in most current policies, it is only triggered after an adjudication of fraud. The fraud exclusion is no barrier to the payment of insurance benefits to fund settlements of claims alleging fraud.

 

Indeed, insurance companies regularly fund Section 10(b) claim settlements, notwithstanding allegations of fraudulent misconduct. Surely Joe is not suggesting that insurers cannot properly fund Section 10(b) settlements? And if Section 10(b) settlements properly can be funded because there has been no adjudication of fraud, why can insurers withhold payment of insurance benefits from Section 11 benefits in the absence of an adjudication of fraud, merely because of unproven allegations of "ill-gotten gains" or even "crooked behavior"?

 

An August 25, 2008 New York Law Journal article by Joshua Sohn of the DLA Piper law firm entitled "Liable Until Proven Innocent" (here) decries the leniency of Section 11 and Section 12(a)(2) pleading requirements. Among other things, Sohn quotes the Supreme Court’s recent Twombley opinion to assert that lenient Section 11 and 12(a)(2) pleading standards will continue to "push cost-conscious defendants to settle even anemic cases."

 

The lenient pleading standards make IPO companies that experience sharp stock price drops likely targets for Section 11 claims. The leniency of the Section 11 liability standards also means that the lawsuits are likely to survive preliminary motions, leaving defendant companies few options other than settling. Because of this heightened susceptibility to dangerous litigation, companies about to conduct an IPO are particularly sensitive to the need for D&O insurance.

 

An IPO company is generally regarded as an attractive insurance prospect, and many insurers compete actively to write the insurance for IPO companies. The confounding thing is that insurers that actively competed for the business and voluntarily undertook to insure an IPO company would later contend that the most likely and most dangerous claim the company would face is uninsurable. Whether or not this coverage position makes the insurance agreement illusory, it certainly raises serious concerns about the utility of the insurance agreement.

 

It will be argued that public policy prohibits insurance for corporate Section 11 liability because the relief sought is restitutionary in nature. As a general matter, the determination of private contractual matters based on public policy grounds raises certain fundamental question about the sources and uses of law. One particular concern is that the supposed requirements of public policy lack a definite point of reference and could become simply a matter of perspective. The notion than insurance for Section 11 claims is against public policy is neither inherent nor absolute, and indeed is an issue on which pertinent parties take a point of view different than followed in recent case law.

 

The SEC’s perspective is particularly relevant to this public policy question. On the one hand, the SEC takes the position (here) that corporate indemnification for ’33 Act liabilities is "against public policy" and unenforceable. On the other hand, the SEC emphatically does not specify that insurance for ’33 Act liabilities is against public policy. To the contrary, the SEC expressly designates (here) as among the expenses that properly may be charged to the costs of a securities offering the premium charged for insurance "which insures or indemnifies directors or officers against any liability they may incur in connection with the registration, offering or sale of such securities."

 

The SEC’s public policy analysis distinguishes between the indemnification of Section 11 liability and the provision of insurance for Section 11 liabilities. The SEC’s statements suggest that in its view public policy does not prohibit the enforcement of policies insuring against Section 11 liability, by contrast to its indemnification.

 

If nothing else, the SEC’s views ought to suggest that what public policy dictates as far the insurability of Section 11 claims is neither self-evident nor universally held. All of which should raise serious concerns about using judicially declared principles of supposed public policy to determine private contractual rights.

 

It was a nearly universal reaction among both D&O underwriters and brokers that this line of case law produced a result that, while perhaps perfectly logical to an insurance lawyer, ran absolutely contrary to marketplace understanding and commercial expectations. It is worth considering that both underwriters (the ones who sell insurance) and brokers (the ones who procure insurance on behalf of insurance buyers) universally agree that D&O policies should cover these kinds of settlements.

 

In response to these concerns, the entire D&O insurance industry has taken steps, as quickly and as vigorously as any insurance-related industry has ever done anything, to try to insert policy language calculated to prevent lawyers from making arguments that while perhaps logical to the lawyers defy the expectations and understandings of the commercial marketplace. The marketplace understands that the compromise of disputed Section 11 claims in no way means that a company has engaged in "crooked behavior" and in fact represents the very contingency for which policyholders buy insurance.

 

Joe’s Counterpoints:

Kevin’s repeated admonishments for my use of the term "crooked behavior" call to mind Judge Posner’s words in the Level 3 decision, a case that perhaps more than any other establishes the public policy rationale relied upon by the CNL Resorts courts.

   

 

An insured incurs no loss within the meaning of the insurance contract by being compelled to return property that it had stolen, even if a more polite word than ‘stolen’ is used to characterize the claim for the property’s return.

 

 

 

Taking a cue from Judge Posner, I should have refrained from use of the pejorative term "crooked", and I regret any possible inadvertently implied mischaracterization of the motive of the corporate issuer in CNL Resorts or other cases.

 

Nonetheless, I will now "politely" set forth a number of rebuttal points.

 

First, I believe the fact that the underlying CNL Resorts litigation, like many other similar litigations, concluded with a settlement and, hence, no evidentiary proof of ill-gotten gain, misses the point of these insurance coverage cases. Regardless of the culpability of the conduct, there could be no liability of the issuer unless the offering was in fact overpriced. To have an insurer pay the amount of the overpricing, rather than have the issuer disgorge it uninsured, results in an unentitled windfall to the issuer.

 

That being said, I share Kevin’s observation of the irony that in these cases of what is in essence strict liability there can be no insurance recovery, but yet insurers routinely pay to cover liabilities resulting from reckless conduct in other securities cases. Ironic, yes, but it is supportive of the point that culpability of conduct is not the issue.

 

Also, I would agree that in most of these cases that are disposed via settlement, the insurer cannot apply one or both of its "conduct exclusions", which with increasing frequency in today’s insurance market are written with requirements of a final adjudication in the underlying proceeding. That may hold true for both the dishonesty exclusion and that for personal profit. The latter would arguably apply to preclude coverage for these settlements, but for an adjudication requirement, and in addition to the uninsurability reasoning of the courts in applying the law and public policy.

 

By no means do these decisions render the insurance agreement illusory, because none of them have applied the uninsurability argument to the individual directors and officers defendants. Thus, in most cases, an allocation should result, but certainly not a complete absence of coverage for all defendants. Although the court in the SR International decision enunciated a public policy argument of having the insurers stand behind the way they market their policies, that was in the context of a dispute over coverage for an underwriter defendant. There is little argument that an underwriter does not receive the proceeds of the offering, and thus its settlement payment cannot be fairly characterized as a disgorgement of ill-gotten gain. Nevertheless, the public policy arguments in that decision give a degree of validity and support to those D&O insurers who have voluntarily attempted to underwrite around the issue by endorsement, notwithstanding what may be the law now in some jurisdictions.

 

I do not want to belabor the seeming contrast between the SEC’s views on indemnification vs. insurance, but I believe the SEC may well not be inclined to enforce an indemnification prohibition in a settlement context where arguably no Section 11 "liability" has been established.

 

Finally, I must raise a bit of skepticism at Kevin’s conclusion that insurance underwriters and brokers are in universal accord as to providing "full" coverage for a Section 11 settlement, and that the debate remains only an arcane one among the wonks in the insurance coverage bar. I cannot speak for any particular insurer on this, but it appears at least some were vigorously contesting this issue before the Eleventh Circuit until its decision last month in CNL Resorts. Yes, the endorsements and new policy language purporting to clarify and grant the coverage are frequently seen in today’s market (and, in full disclosure, I have even crafted some of the endorsements and policy language at the request of clients), but I remain reluctant to concede the approach is universal.

 

Afterword: Consistent with the rules of engagement that I established for this colloquy, Joe gets the last word, so I will offer no surrebuttal. I would like to thank Joe for his willingness to engage on this topic and to offer his views. I would also like to invite readers to chime in on the debate using the blog’s comment feature. (Please note that you can add a comment without providing identifying information, so it possible to add comments anonymously.)

 

In a statement issued on Tuesday evening (here), the Federal Reserve announced that it had authorized a loan of up to $85 billion to American International Group. This move is described in detail in a September 17, 2008 Wall Street Journal article entitled "U.S. to Take Over AIG in a $85 Billion Bailout" (here). Bloomberg’s article describing the development can be found here.

 

The Outlines of the Loan Facility

The loan facility, which the statement says has been extended pursuant to Section 13(3) of the Federal Reserve Act, has been "designed to protect the interests of the U.S. government and taxpayers." According to the Real Time Economics blog (here), the only other time this specific Fed power has been exercised since the Depression era was in connection with the Bear Stearns bailout.

 

The Fed statement says that it exercised its authority because of adverse economic effects that would follow from a "disorderly failure" of AIG. The loan facility is designed to permit AIG to "meet obligations" in order to "facilitate a process under which AIG will sell certain of its businesses in an orderly manner."

 

The facility has a 24-month term. The interest rate is set at three month LIBOR plus 850 basis points. Three month LIBOR is a variable rate that resets weekly. The current weekly rate (here) is 2.81%, so the current interest rate on this loan facility is 11.31% — pretty hefty. Just keep in mind that annual (simple) interest of 11.31% on $1 billion is $113.1 million. On $10 billion it is $1.131 billion. And on $85 billion it is $9.61 billion.

 

The loan is collateralized by all of the assets of AIG and of its non-regulated subsidiaries. (The good news here is that the assets of the regulated subsidiaries – the insurance companies – are off limits.) The loan is to be repaid from asset sale proceeds.

 

According to the Fed statement, the government "will receive a 79.9% equity interest" in AIG, with the right to veto dividends to common and preferred shareholders.

 

The size of the facility presumably was set to accommodate all likely requirements, so AIG may or may not draw down all of it. But AIG will most likely draw down a very large part of it. AIG will have to repay its borrowings (plus interest). In referring to the means of repayment, the press release refers to the orderly sale of "businesses," so one can assume that the non-core subsidiaries are on the blocks for an "orderly" sale.

 

Questions about the Loan Facility

The problem for AIG is that sale of its non-core subsidiaries alone may not be sufficient to pay back even half of $85 billion. The Deal Journal blog estimates (here) that sales of AIG’s non-core subsidiaries and minority interests might raise "as much as $42 billion" – and that, I might add, is before taxes. (I think Uncle Sam will insist on the payment of all applicable taxes.) Which raises the question whether the sale of "businesses" specifically contemplates the sale of some or all of AIG’s core insurance operations?

 

Left unanswered in the Fed press release is the question of what this development means for AIG’s continuing business operations. The primary goal of the Fed facility is the orderly sale (as opposed to the "disorderly failure," as the Fed statement put it) of AIG’s businesses. What does this imply about the future of AIG’s operating companies? And what will be left of AIG after the "orderly sale"?

 

Presumably, the answers to many of these questions will become apparent in the days ahead. In the meantime, there are some things that everyone will want to know. I have posed some of these questions below. Please note that many of these questions may simply be a reflection of the limited amount of information currently available. Many of these questions may appear simple-minded once the information is known. But based on what we know so far, here are the other things we still need to know:

 

1. Who will run the company? Is current senior management to remain in place, or will AIG get its third CEO this year? (For the record, the government did embed new management at Fannie Mae and Freddie Mac as part of the recent takeover.). How about the Board of Directors, will they also be replaced?

 

UPDATE: The New York Times reports (here) that AIG CEO Robert Willumstad will be replaced by Edward M. Liddy, the former chairman of Allstate Corporation.

 

2. What exactly does government ownership of 79.9% of the company equity mean? Is this just a shorthand way of saying that the government is entitled roughly 80% of any later liquidation? Or is there more to it than that?

 

For example, does the government want the value of its ownership interest to grow? What will the government ultimately do with its ownership interest? Will the government sell its interest, and if so, when, to whom, for what price, and under what circumstance? Why is the government now the majority owner of a major insurance company? Does the government want its insurance company to compete and succeed in a competitive marketplace against investor owned insurance companies?

 

3. The government wants to get repaid, so it wants the "orderly sale" of the businesses to produce sales values sufficient to effect repayment. That implies that the operating companies should continue operating. But among the insurance companies, for example, there are many practical questions that only active and engaged management can decide – risk appetite, level of pricing aggressiveness, extent of reinsurance, limit exposures, prohibited classes, and so on. All of these decisions must now take place under potentially unusual conditions, in effect under the supervision of a government appointed caretaker/liquidator?

 

4. What impact will these developments have on credit ratings, both at the parent company level and at the insurance subsidiary level? The fact the company’s primary mission now seems to be a slow-motion liquidation is clearly a relevant factor, as are the unusual operating conditions. In addition, I would expect that all of AIG’s other debt is subordinate to the Fed loan, which also seems relevant to financial strength ratings.

 

5. What happens if $85 billion is not enough? This is not as absurd of a question as it might seem at first glance. Keep in mind that AIG just raised $20 billion in the second quarter and that clearly was not enough. What does the current lending facility imply about the future – for AIG, for taxpayers, for the economy?

 

6. What about the credit rating for the U.S. government? How far can this go? The U.S. government just assumed responsibility for $5 trillion in Fannie Mae and Freddie Mac debt. When do we start to get concerned about the government’s balance sheet? When do we start to get concerned about the ability of the U.S. to meet of all of its obligations?

 

Policyholders’ Interests

Finally, I must address the interests of policyholders. On Tuesday, AIG released a statement (here) that its insurance subsidiaries "remain adequately capitalized and fully capable of meeting their obligations to policyholders." Along those lines, it is important to keep in mind that AIG’s current predicament is not the result of insurance losses, so the separately capitalized insurance companies’ ability to meet its obligations essentially remains unchanged.

 

Moreover, the collateral securing the Fed’s lending facility does not include the insurance companies’ assets, so even if the parent company heads south in a big way despite the $85 billion loan, the insurance companies’ existing surplus should remain to address policyholder claims, subject of course to the effects of claims payment.

 

In the days ahead it will be very important to understand how the current operating circumstances will affect the insurance companies and their operations, and in particular whether there are any other implications for policyholder surplus and the insurance companies’ claims paying ability.

 

Since the earliest days of the subprime litigation wave, one of the recurring questions has been whether the wave would spread beyond the financial sector. The question remains, but allegations in a new securities lawsuit suggest that circumstances arising from the subprime crisis are affecting a diverse variety of companies, and by extension the claims asserted against them.

 

According to their press release (here), on September 16, 2008, plaintiffs’ counsel filed a securities class action lawsuit in the United States District Court for the Southern District of California against NextWave Wireless and certain of its directors and officers. NextWave is a mobile broadband and multimedia technology company that develops, produces and markets mobile multimedia and wireless broadband products. A copy of the complaint can be found here.

 

According to the press release, the complaint alleges that:

 

Defendants issued materially false and misleading statements regarding the Company’s business and financial results. As a result of defendants’ false statements, NextWave stock traded at artificially inflated prices during the Class Period, reaching as high as $10.10 per share in June 2007.

 

On August 7, 2008, after the market closed, Nextwave issued its second quarter 2008 financial results, announcing it only had $71.1 million in cash and similar instruments available as of June 30, 2008 and, unless it raised money, its cash would run out at the beginning of October 2008. As a result, the Company was seeking financing that would give the Company enough money to operate through June 2009. On this news, NextWave’s stock fell $1.90 per share to close at $0.95 per share, a one-day decline of 67%.

 

According to the complaint, the true facts, which were known by the defendants but concealed from the investing public during the Class Period, were as follows: (a) NextWave did not have adequate sources of liquidity to continue operations as it executed its growth strategy and continued making aggressive worldwide acquisitions; (b) defendants had no reasonable basis to make favorable statements that the Company’s WiMAX semiconductor products would be available for commercial sale in the first half of 2008; (c) NextWave’s growth and acquisition strategy was not financially successful and did not provide the basis for continued growth or financial success because it was straining NextWave’s fragile liquidity position and NextWave did not have the financial resources to continue to operate its world-wide operations through the end of 2008; (d) NextWave failed to timely disclose that it had invested all of its marketable securities in extremely high-risk and illiquid auction rate securities; and (e) NextWave’s ability to continue as a going concern was seriously in question by reason of the facts alleged in subparagraphs (a)-(d) above.

 

The most interesting part about these allegations to me is the reference to the company’s investment in auction rate securities. The complaint itself further alleges with respect to these "extremely high-risk and illiquid auction rate securities" that NextWave "had misrepresented these investments as marketable securities on its balance sheet included in its financial statements disseminated in its Form 10-K and 10-Q and press release."

 

There have of course been many prior lawsuits against investment banks and broker-dealers in which it is alleged that the financial institutions misrepresented the risks of auction rate securities. But this new lawsuit against NextWave represents the first instance of which I am aware in which an auction rate investor has been sued for failing to disclose its exposure to auction rate securities investments. Obviously, there are a lot of other allegations in the lawsuit, but the auction rate investments allegations are an important part of the complaint and, if nothing else, are noteworthy.

 

The allegations about the company’s alleged balance sheet misclassification of its auction rate investments is of particular concern. Many companies (and other entities) hold auction rate securities investments, and all of these entities have been struggling both with valuation issues and with balance sheet classification issues. These classification and disclosure issues affect not just auction rate related investments but subprime and other mortgage-backed investments as well. At least theoretically, plaintiffs’ lawyers could allege similar investment disclosure and asset classification issues in connection with these companies.

 

Perhaps I am getting ahead of myself, but I also wonder whether similar "failure to disclose investment exposure" allegations might be alleged against companies that will be reporting significant write-downs in their holdings of securities of, for example, Fannie Mae, Freddie Mac, Lehman Brothers, and AIG. Admittedly, this may be a far-fetched possibility at this point. But some companies’ write-downs of their investments in those assets could be material, which in turn could affect the reporting companies’ own stock market valuations. If the impact is significant, angry investors might consider their litigation alternatives.

 

Another Credit Crisis Lawsuit: There was also a more conventional credit crisis lawsuit filed today. According to the plaintiffs’ counsel’s September 16, 2008 press release (here), plaintiffs have filed a securities class action lawsuit against BankUnited Financial Corp. 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

 

Defendants made false and misleading statements about BankUnited. Specifically, defendants misrepresented: (a) the losses the Company was likely to suffer due to BankUnited’s poor underwriting standards, which losses would occur once interest rates reset on the billions of dollars of pay-option arms (adjustable rate mortgages where borrowers had the ability to choose their payment amount during the initial period of the loan); (b) BankUnited’s sketchy appraisal process, which permitted borrowers to obtain mortgages in excess of their ability to pay and in excess of the value of the underlying property; and (c) BankUnited’s policies with regard to "piggy-back" loans, which are essentially second mortgages made at the time a home is purchased to fund a down payment.

 

The BankUnited lawsuit is the latest to raise allegations involving Option ARM mortgages, which I have discussed in prior posts, most recently here.

 

Run the Numbers: Many readers know that I have been tracking subprime and credit crisis-related securities lawsuits. My running tally can be accessed here. As time has gone by, definitional issues have become increasingly challenging. The NextWave lawsuit may present the most significant definitional challenge to date, because the auction rate investment allegations arguably are a peripheral part of the complaint.

 

I could go either way on this one, but after some thought, I have decided to include the NextWave lawsuit in my count, simply due to the fact that the company’s financial problems apparently were due in part to its investments in auction rate securities. Reasonable minds could differ on whether or not to include the lawsuit.

 

But with the addition of the NextWave and BankUnited lawsuits, the current tally of subprime and credit crisis-related lawsuits now stands at 114, of which 74 have been filed in 2008.

 

Dear Bob, you might not remember me, but I used to work at AIG: If you have not yet seen it, you must read the September 16, 2008 letter (here) that Maurice "Hank" Greenberg, AIG’s former Chairman and CEO and current Chairman and CEO of C.V. Starr, to now-former AIG Chairman and CEO Robert Willumstad.

 

I can’t imagine why Greenberg thinks Willumstad might have been concerned that Greenberg would "overshadow" him. Willumstad undoubtedly was reassured that, although Greenberg did feel compelled to note "you and the Board have presided over the virtual destruction of shareholder value built up over 35 years," it was not Greenberg’s "intention to point fingers or be critical."

 

Hat tip to the Wall Street Journal for the link.

 

Because of trees felled last night as Ike’s remnants swept through Ohio, I was unable to make it to the office today. I spent more or less the entire day on the telephone talking about AIG, looking out at my yard strewn with fallen tree limbs, branches, twigs and leaves – a visually suitable tableau give the winds that ripped through Wall Street over the last 48 hours.

 

With respect to AIG, can I just say that today’s mainstream media coverage regarding AIG was absolutely terrible? For most of the day, various news reports seemed to suggest that New York insurance regulators had authorized AIG’s insurance subsidiaries to loan the parent company $20 billion. However, when the transcript of New York Governor David Paterson’s Monday afternoon press conference (here) was later made available on the Governor’s website, it became clear that what the regulators had authorized was quite a bit different than depicted in the media.

 

As the transcript explains (if you read the whole thing), the regulators have authorized an "asset swap." The idea is that the insurance subsidiaries are swapping the more liquid assets they hold for less liquid assets of equal or greater value held by the parent company, so that the parent company can post the liquid assets as collateral. The transaction is further explained in a CFO.com article here.

 

The governor himself noted that this swap transaction alone is not sufficient to see AIG through this current crisis, as the working number for AIG’s current requirements is $40 billion. Much about the asset swap transaction "depends" – that is, it depends on the company’s ability to raise the additional funds it requires, it depends on the actual assets that are transferred, it depends on what further capital requirements AIG may have in this rapidly changing environment.

 

The critical question of the sufficiency of policyholder protection in light of the asset swap will depend on the quality of the assets exchanged. One can hope that given what is at stake that there is a great deal of transparency concerning the assets the insurance subsidiaries receive. Given the regulators’ involvement, one can also hope that policyholders’ interests will not be subordinated to the interests of AIG’s shareholders or bondholders.

 

In the final analysis, AIG’s ultimate circumstances may finally depend on what the credit rating agencies do. CNN is reporting tonight (here) that Fitch’s has already downgraded AIG’s financial ratings, which potentially could trigger significant additional collateral requirements on the AIG’s credit default swap contracts, perhaps as much as $13.3 billion. The specifics regarding the Fitch downgrades can be found here. Following suit, S&P has also downgraded AIG’s counterparty and financial strength ratings (refer here), with the lowered ratings remaining on credit watch "with negative implications." Apparently the downgrades fully considered the potential benefits to AIG as a result of the asset swap transaction.

 

Perhaps of equally significant (if not greater) concern to readers of this blog is the action this evening by A.M. Best’s to downgrade AIG’s property/casualty insurance financial strength rating to A (Excellent) from A+ (Superior), about which refer here.

 

UPDATE: A September 16, 2008 Financial Times article entitled "Downgrades Deepen AIG Woes" can be found here. Moody’s has apparently downgraded AIG as well (refer here).

 

There will be further material developments ahead. The ultimate outcome remains to be seen. The company itself did not publicly comment as these events unfolded today, but some reports suggest that there will be a company statement prior to the opening of the markets tomorrow.

 

About Lehman: At the same time as AIG’s struggles, the details of Lehman’s demise have started to emerge, starting with the company’s Monday morning bankruptcy petition, which can be found here. The Dealbreaker blog has distilled some of the more interesting tidbits from the petition, here.

 

A more scholarly look at the Lehman petition can be found on the Bankruptcy Litigation Blog (here), which notes that the petition bears the indicia of having been prepared in haste. The blog also notes that as a result of recent bankruptcy law revisions, Lehman’s petition may face some rather complicated challenges. (Hat tip to Francis Pileggi of the Delaware Corporate and Commercial Litigation Blog, here, for the link to the Bankruptcy Litigation Blog.)

 

Roger Parloff also discusses on the Legal Pad blog (here) the challenges that Lehman’s petition presents. As statements Parloff quotes on his blog make clear, Lehman may not be able to enjoy one of the primary benefits usually available to company’s filing a bankruptcy petition, the automatic stay. Bankruptcy laws relating exclusively to investment banks provide that Lehman’s transaction counterparties can now, even after the petition filing, seek to terminate their contracts with Lehman, which could further exacerbate the current distress.

 

And on another note, CFO.com has an interesting article (here) asking the question whether Lehman’s creditors can try to recoup the $5.7 billion in bonuses that Lehman paid its employees in December 2007.

 

The damage from Lehman’s collapse will be widespread, as investors holding its shares and even its debt securities will likely see little or nothing on their investment. This asset wipeout comes on the heels of the Fannie Mae and Freddie Mac takeout, and at the same time as the precipitous decline in AIG’s shares. All of this means that in a few short days a significant chunk of asset valuation has disappeared (and that is not even counting the overall decline in market values today). These investment losses are going to hit a lot of other companies, not to mention pensions, mutual funds, hedge funds, other insurance companies, endowment funds and so on. These losses will have to be reckoned in the weeks and months to come.

 

The extent of the consequences from these events may be difficult to foresee even now,  though the events have been widely reported. Who could have foreseen that when Ike came roaring ashore early Saturday morning in Galveston that on Monday morning trees would be down all over Northeast Ohio?

 

For Those Who Can’t Wait: If you are (like me) one of those people who need to know what it all means, you will want to refer to Professor Davidoff’s overview on the Dealbook blog (here). An analysis that takes a darker, more cynical view of these events can be found on The Big Picture blog (here).