The wave of subprime-related securities class action litigation has continued to spread, as plaintiffs’ lawyers have filed new securities lawsuits against two different companies.

First, according to their March 12, 2008 press release (here), plaintiffs’ lawyers have filed a securities class action lawsuit in the United States District Court for the Northern District of California (complaint here), against residential mortgage insurer The PMI Group. The lawsuit follows the company’s March 3, 2008 announcement (here), in connection with its fourth quarter earnings release, that it would delay filing its Form 10-K for year-end 2007 due to delays in obtaining 2007 financial results from recently downgraded bond insurer FGIC , in which PMI Group has a 40% ownership interest.

According to the plaintiffs’ attorneys’ press release, the complaint alleges that the defendants failed to disclose to investors that:

(a) the Company’s investment in FGIC was materially impaired as FGIC’s bond insurance arm, Financial Guaranty, had significant exposure to defaults on bonds it insured due to the plunge in value of mortgage debt; (b) the Company was materially overstating its financial results by failing to properly value its investment in FGIC and by failing to write down that investment in a timely fashion in violation of Generally Accepted Accounting Principles (“GAAP”); (c) the Company was not adequately accounting for its loss reserves in violation of GAAP, causing its financial results to be materially misstated; (d) the Company failed to engage in proper underwriting practices for its book of business related to insurance written in 2005 through most of 2007; (e) the Company had far greater exposure to anticipated losses and defaults related to its book of business related to insurance written in 2005 through most of 2007 than it had previously disclosed; (f) given the deterioration and the increased volatility in the subprime market, the Company would be forced to tighten its standards and stop writing insurance policies to certain categories of borrowers which would have a direct material negative impact on its book of business going forward; and (g) given the increased volatility in the subprime market, the Company had no reasonable basis to make projections about its incurred losses or about its new insurance written.

The second of the new securities class action lawsuits involves Société Générale. As I noted in a prior post (here), SocGen has previously been sued in a French court on behalf of 130 individual investors and certain companies. But according to their March 12, 2008 press release (here), plaintiffs’ lawyers in the U.S. have now filed an action in the United States District Court for the Southern District of New York under. U.S. securities laws against SocGen and its Chairman and CEO. The complaint can be found here.

According the plaintiffs’ press release, the plaintiffs allege that the defendants

·        made false and misleading statements and concealed material adverse information regarding SocGen’s exposure to subprime loans, collateralized debt obligations ("CDOs") and SocGen’s internal controls

·        touted SocGen’s conservative management, risk control, and expertise in risk analysis and structured finance, including CDO vehicles

·        misled investors by announcing that it had "very little exposure" to the subprime segment

·        ignored or failed to act upon numerous alerts which should have led to the uncovering of Jerome Kerviel’s massive irregular trading activity from 2005 through early 2008

The press release states that the case “also involves alleged insider trading by SocGen’s top U.S. executive and board member, Robert A. Day (I discussed Day’s trading in the company’s shares at length in my prior post, here).

One of the interesting features of the SocGen securities lawsuit is the class of investors on whose behalf the lawsuit purports to be brought. The complaint describes the class as consisting of all purchasers of the company’s American Depositary Receipts (which trade on the OTC market), and “all U.S. citizens who purchased SocGen securities on any exchange,” between August 1, 2005 and January 23, 2008.

By narrowing the class to include only investors who bought ADRs on the OTC and U.S. investors in general regardless of where they bought their SocGen securities, the plaintiffs clearly are seeking to avoid the jurisdictional and class certification issues that can arise in U.S. class actions against overseas companies involving overseas investors who bought their shares overseas.

As I have discussed in prior posts (most recently here), courts have wrestled with the so-called “f-cubed” litigants (foreign investors who bought their shares in foreign companies on foreign exchanges) and those issues have created complicated jurisdictional and class certification issues (as discussed here and here). The SocGen plaintiffs’ complaint seems calculated to try to avoid these issues, and possibly even to try to avoid conflicts with the prior French lawsuit.

The exclusion of the “f-cubed” litigants from the purported class does raise the question of where these investors are left, particularly if they would like to pursue remedies under U.S. securities laws. Clearly, they retain the option of bringing individual or group actions – what might be called the “left out” actions, by contrast to the more common “opt out” actions. As noted on the Securities Litigation Watch blog, here, that is what has happened with the overseas investors who were precluded from the class in the Vivendi class action; they have filed extensive individual actions.

While the subprime litigation wave has involved lawsuits against a wide variety of kinds of companies, the lawsuit against The PMI Group is the first case of which I am aware involving a residential mortgage insurer – although the lawsuit arises in part due to The PMI Group’s investment in troubled bond insurer FGIC, and there have been numerous prior subprime-related lawsuits against bond insurers.

In any event, as reflected in my running tally of subprime related securities lawsuits (which can be accessed here), the addition of these two lawsuits brings the total of subprime-related securities lawsuits to 49, ten of which have been filed in 2008.

Federal Securities Class Action to Proceed State Court: As discussed at length in a prior post (here) concerning two securities class actions that have been launched against mortgage-backed asset securitizers, the plaintiffs’ lawyers filing these actions chose to file the lawsuits in state court, in reliance on the concurrent state court jurisdiction under the ’33 Act. As I also noted in the prior post, the defendants in Luther v Countrywide Home Loans Servicing removed the case to federal court.

In a February 28, 2009 order (here), Judge Mariana R. Pfaelzer held that the lawsuit had not been properly removed to federal court, and granted the plaintiffs’ motion to remand the case back to state court.

The defendants had based arguments in support of removal on the Class Action Fairness Act of 2005, which provides that a state court class action is removable to federal court where the amount in controversy is greater than $5 million and any class member is a citizen of a state different than the defendant. The parties agreed that the conditions were met in this case. In seeking remand, the plaintiffs relied on the express provision of Section 22(a) of the Securities Act of 1933 that prohibits the removal from state court to federal court of an action under the ’33 Act.

In reliance on principals of statutory construction, Judge Pfaelzer concluded that the specific principals in the ’33 Act must control. She said that “the Court continues to harbor significant doubt that CAFA provides removal jurisdiction in the face of the 1933 Act’s absolute prohibition on removal. Accordingly, the Court must remand the case to state court.”

Given the language in Section 22(a), Judge Pfaelzer’s decision seems correct. However, the outcome seems undesirable. There is no way to know for sure why the plaintiffs’ lawyers seek to proceed in state court. As I discussed in my prior post, the likeliest explanation is that the plaintiffs intend to take the position that the provisions and requirements of the PSLRA do not apply to a ’33 Act case in state court. It certainly does seem like putting federal securities class actions in state court opens up a can of worms. It will be interesting to see (but difficult to track) what happens with these class action lawsuits.

Speakers’ Corner: On Friday, March 14, 2008, I will be participating in a webcast sponsored by RiskMetrics Group entitled “Securities Litigation – What European Investors Need to Know.” The panel will be moderated by Adam Savett, of the Risk Metrics Group and author of the Securities Litigation Watch blog. Also on the panel will be Eric Belfi of Labaton Sucharow and an additional guest speaker. Information regarding the webcast can be found here.

You will never read a headline that says “Financial Institution Fires Rogue Trader Who Racked Up Massive Gains.” Therein lies the fundamental tension in financial institution risk management. It is not a merely cynical view that financial institutions tacitly tolerate control lapses as long as gains result – indeed, some of the leading commentators place the blame for the current credit crisis squarely under the heading of failed risk management, caused by practices that flourished during years of investment gains.

For example, in a March 11, 2008, Financial Times article (here), one commentator attributes the current crisis to “the biggest failure of ratings and risk management ever.” Similarly, the Seeking Alpha blog, commenting (here) on the contributions that hedge funds have made “to the evaporation of the essential capital equity value of the large financial institutions,” notes that in the lead-up to the current crisis, hedge funds created outsized gains “without managing the risks” and that banks themselves created their own in-house hedge funds to “avoid risk management, technology burden, and regulatory charges.” Many of the recent massive write-downs relate to “devalued subprime assets which had not been monitored properly and which turned out to be cheap due to low risk management standards or lack of risk management at all.”

The most fundamental control weakness may be the system of compensation that rewards risk taking. As noted in a January 28, 2008 Washington Post op-ed column (here), “bankers bet with their bank’s capital, not their own. If the bet goes right, they get a huge bonus; if it misfires, that’s the shareholders’ problem.” CFO.com noted in a March 11, 2008 article (here) that “sidelining caution in favor potential profit is not particularly difficult in a culture built on producer worship.” The CFO.com article goes on to describe practices at various financial institutions that defeated the institutions’ highly touted risk controls.

Within this environment, it is hardly surprising that individuals might feel emboldened to take extraordinary risks, and occasionally produce inconveniently large losses. The infamous case of Soc Gen trader Jérôme Kerviel (discussed previously here) is the best known recent example. An even more recent albeit less spectacular example involved Evan Brent Dooley, who lost $141.5 million for MF Global Ltd. in one day’s wrong way bets on the direction of the price of wheat.

In the February 29, 2008 Wall Street Journal article (here) about the incident, Dooley “blamed the trading loss on the computer he was using. The system ‘failed on a lot of things,’ he said, including problems in ‘settling limits.’” Indeed, the same article quotes MF Global’s CEO as “acknowledging that existing internal controls could have stopped Mr. Dooley’s trades from being processed – but were turned off in a few cases to allow for speedier transactions by brokers at the firm who traded for themselves or took customer order by phone.”

Large losses often produce lawsuits, and so it comes as no surprise that plaintiffs’ lawyers have launched a securities lawsuit against MF Global, its corporate parent, and certain of its directors and officers. A copy of the plaintiffs’ lawyers’ March 10, 2008 press release can be found here. The plaintiffs’ complaint (here) focuses on the statements in the company’s Registration Statement and Prospectus, prepared in connection with the company’s July 19, 2007 IPO, particularly the sections headed “Disciplined Approach to Risk.” The complaint alleges that the statements in the Registration Statement and Prospectus about risk controls were false and misleading.

UPDATE: On March 12, 2008, plaintiffs’ attorneys’ announced (here) that they had filed a securities class action lawsuit against Societe General and certain of its directors and officers, on behalf of Soc Gen shareholders (both those who purchased their shares in the U.S. as well as those who purchased their shares overseas), alleging among other things that defendants had made mispreresentations and omissions, including allegations that defendants had misleadingly  "touted SocGen’s conservative management, risk control, and expertise in risk analysis and structured finance." The plaintiffs specifically refer to the company’s "lack of sufficient controls " that permitted Kerviel’s unauthorized trading.

The complaint alleges that the defendants not only misrepresented the company’s risk controls, but “failed to disclose that in an effort to speed trades and to be ‘efficient’, MF had suspended or eliminated its own internal risk management technical and human controls and supervision, and failed to disclose that it eliminated credit and risk analysis and buying power limits and controls from its systems, effectively allowing any MF employee to place order without regard to the account’s satisfaction or margin requirements, collateral or ability to pay.”

Companies with problems arising from the activities of a single trader are not the only ones facing securities litigation allegations based on alleged breakdowns in controls. As the CFO.com article linked to above catalogues, many financial institutions’ recent massive write-downs may be tied to exposures arising from the breakdown or circumvention of controls. Allegations based on these control failures are a common feature of many of the subprime-related securities class action lawsuits.

These allegations have arisen in lawsuits against companies as diverse as Ambac Financial Group (which plaintiffs allege, among other things, lacked requisite internal controls to ensure that underwriting guidelines were followed); Accredited Home Lenders Holding Company (against which it is alleged, among other things, that management actively encourage circumvention of internal guidelines); and Countrywide Financial Corporation.

To be sure, many if not most of the subprime-related securities lawsuits also contain allegations of accounting and financial fraud, but underlying the financial disclosure allegations are claims based on breakdowns in controls. Shareholders who believed that prior gains were the product of a controlled risk environment may well object when they learn of losses arising from the circumvention of claimed risk controls.

The circumvention of controls may ultimately proved to be the unifying theme in subprime litigation, arising not just in claims involving public companies and their shareholders, but also in claims involving securitizers, mortgage originators, bond insurers, rating agencies, hedge funds, and a multitude of other marketplace participants. But as the MF Global case proves, the damages that can arise from control breakdowns are hardly limited to the subprime context alone. The MF Global case also shows how quickly damages can accrue – whether the breakdown involves a single trader or more systemic activity.

Evading Constraints: An American Heritage?: Those contemplating the origins of the conduct described above may want to consider an historical explanation.  In Throes of Democracy (here), a new history of America during the years 1829 to 1877, by Walter A. McDougall, the Pulitzer-Prize winning historian from the University of Pennsylvania, Mr. McDougall writes that “Americans tolerate and even encourage corruption, so long as it appears creative in the sense of evading artificial constraints, hastening development and expanding opportunity.” He adds that “since the United States has been the most dynamic nation on earth…it is only to be expected that every age of American history is awash in old and new forms of corruption at every level of business and government.”

McDougal’s words may provide an explanation of sorts, but not a defense.

Now This: Others may be spellbound by the news involving Eliot Spitzer, but personally I am more consumed with the recent information regarding Dawn Wells. Wells, you may recall, played the part of Mary Ann in the TV show “Gilligan’s Island.” According to news reports (here – check out the picture), Wells is “serving six month’s unsupervised probation after allegedly being caught with marijuana in her car.”

Those of you who think this news provides additional information relevant to the perennial “Mary Ann or Ginger” debate should also be aware that at the time of her arrest, Wells was on her way home from a party for her 69th birthday. 

The official Dawn Wells website may be found here.

Last week, I added a post (here) discussing the March 2, 2008 paper entitled “How the Merits Matter: D&O Insurance and Securities Settlements” (here) by Connecticut Law Professor Tom Baker and Fordham Law Professor Sean Griffith. In response to my invitation, Professor Griffith prepared a reply to my comments, which is as follows:

Before beginning, I’d like to thank Kevin for his careful and thoughtful reading of our paper and for his many kind words and comments. Kevin’s comments have improved all of our papers in this area, and they will surely improve this one. I do, however, have a few remarks to make in response to three comments Kevin made towards the end of his write-up. I’ll address: (1) the impact of disclosure on insurance, (2) the possibility that additional disclosure will increase the incidence of lawsuits against corporate insureds, and (3) the ways in which additional disclosure will make the world a better place.

1.         In his review of our paper, Kevin writes that Baker and I “do not seem to have reviewed the idea of compelled disclosure with anyone in the insurance industry.” Not so. We have indeed run the idea of additional disclosure by folks in the insurance industry. In fact, I well remember one of the first conversations I had on this subject. I was working on an earlier paper (here) that proposed mandatory disclosure of D&O insurance details when I received a voicemail message from one of the broker’s I’d been talking to. He excoriated me on the message, offering a stream of expletives that would have made George Carlin blush. He’d read my draft (or, at least the title) and, I gathered, was rather displeased at the prospect of public disclosure of D&O insurance information. This, I believe, is the general reaction, of folks in the insurance industry to the proposal, although their reactions are typically more calmly expressed.

I am neither surprised nor particularly bothered by this reaction. First, it is hardly surprising that more transparency within a market would make an intermediary’s life more difficult. Intermediaries will worry that their profit margins will be eroded away if their customers can see the price paid by comparable companies. Buyers will insist that brokers get them an equally good deal as a competitor or justify why they can’t. But why is that a bad thing? What’s bad for the broker looks good for the consumer. Moreover, brokers often say that they do more than just price a coverage package. If that’s really true, then there will be a place in the market for them post-disclosure. They’ll still be providing a service that’s not available elsewhere. But if it’s not true, then the broker’s role starts to look like waste, and why wouldn’t we then want to disintermediate the market and, perhaps, let risk managers build their own coverage towers?

Second, moving to the insurer’s perspective, I’m not sure that disclosure would be bad. It might be a problem if the insurer is offering discounts for some clients but not others on the basis of factors that are not risk-related, perhaps because a buyer’s price on their D&O program is tied to the fact that they’re buying a (more expensive) general liability policy from the same insurer. (Some suggested to us that tying arrangements of this sort occur in the D&O market.) If we had a disclosure rule, we can expect buyers to demand the same D&O premiums as all similarly situated companies, which would make it harder to engage in tying arrangements. The only valid basis for an insurer to offer different prices would be differences in risk. Underwriters would be in the position of having to articulate why Company A is a better risk than Company B. This would obviously be good for the buyer, but I suspect in the long term it would be good for the seller too. It would focus underwriters on what matters—risk-assessment—and inhibit their ability to make sales that discriminate on some other basis (like tying). From the insurer’s perspective, that’s probably a good thing because insurance that is sold with better risk assessment up front is less likely to lead to losses down the road than insurance that is sold on some other basis.

Now, I don’t know how any of that would ultimately play out. I’m just skeptical of the gloom-and-doom-for-the-industry story. I suspect that those within the industry who are doing what the industry is supposed to do—assessing risk and tailoring coverage—will survive. Also, to be honest, my concern is not so much with the insurance industry as it is with the corporations buying the insurance. And, frankly, when anyone other than the consumer complains about market reform, that’s usually a sign that market reform is a good idea. Producers and (especially) intermediaries have shown themselves across industries and throughout history to be opposed to reforms that enhance competition. I suspect that this market reform would benefit the consumer in a variety of ways, not just in the bottom line price paid by insureds, but more about that in my response to #3, below.

2.         Second point. Disclosure would be bad for corporate insureds, Kevin suggests, because the additional disclosure will make them “lawsuit targets.” In other words, the incidence of lawsuits will go up if plaintiffs lawyers know more about corporate insureds’ coverage packages.

We here this objection fairly often, but I think it’s easily disproven. Here’s how: First, everybody knows that virtually every public company in the US carries D&O insurance. Second, everybody knows that average settlements are much less than average coverage limits (in spite of the rare high profile above-limits settlement, just look at Tillinghast, Cornerstone, or NERA—average limits far exceed average settlements). Those two things being true, plaintiffs’ lawyers needn’t fret about insurance when they file claims. They can reasonably assume that coverage will be there. Moreover, insurance coverage is one of the first disclosures that the parties must make once they’re in litigation. If, in the rather unlikely event that a corporate defendant is not well covered, the plaintiffs’ lawyer can drop the claim before their sunk costs have gotten too large. Bottom line: currently, plaintiffs’ law firms reasonably assume that most corporate defendants will have sufficient D&O coverage to fund claims, and they file any time they can put together the basic elements of liability. If Tom and I got the disclosure rule we want, true, plaintiffs law firms would know the coverage profile of the corporate defendant, and they’d file any time they could put together the basic elements of liability. In other words, the additional disclosure would not be a boon to the plaintiffs’ bar, and the incidence of suit would be about the same.

3.         Kevin also remarks that although we, as academic researchers, would benefit from additional disclosure (true!), we haven’t really specified how additional disclosure would deter securities violations. 

            First, regarding Tom’s and my self-interest. Yes, if we got the disclosure rule we want, we’d crunch the data in more papers. But, let’s face it, we’re not going to get famous doing this. And Tom and I both have tenure, so we don’t really have career incentives that distort our devotion, putting it somewhat grandly, to truth and justice. We want the additional disclosure because we think it would be good for the world and we write the papers because we think the world ought to know what’s good for it.

            Okay, so why would additional disclosure be good for the world? Or, more concretely, how would it deter securities law violations? 

As we said in the papers about underwriting, disclosure of D&O pricing, limits, and coverage structure would enable financial analysts to use this information as a proxy for downside risk and, on the basis of that proxy, to change their valuation of corporate insureds. With enough people in the market using this information (which one might assume on the basis of the efficient capital markets hypothesis), insurers’ collective assessment of a prospective insured’s risk should have a direct impact on the prospective insured’s share price. And, last step, because managers care about share price, anything that has an effect on it (e.g., wobbly corporate governance structures) is something they’re likely to address. So disclosure of D&O pricing, limits, and coverage structure would improve corporate governance. 

What’s different in this paper is that we think the required disclosures should be broadened. Not only should corporations be made to disclose their limits, pricing, and coverage structure on a regular basis (with each renewal), but also any time a corporation settles a securities claim, they should be required to disclose how the settlement is funded. E.g., What amount comes from insurers? What amount comes from the company? Putting this information together with information about the corporate insured’s coverage package, financial analysts and capital market participants ought to be able, as we say in the paper, to assess “which corporations are likely to have engaged in bad acts and which have not.” In other words, which corporations got stuck settling a nuisance claim and which allowed some form of fraud to occur.

How would analysts be able to draw this conclusion? Consider a settlement well within total limits to which a corporate insured nevertheless contributes a substantial amount. The insured’s contribution in this case might indicate that the insurers were able to cash in their coverage defense for savings off of their full exposure. Granted it might indicate other things as well, but if I were a financial analyst, I’d want to know why did the company pay when it had more limits available. And if the insurers had a strong coverage defense, doesn’t that suggest that there was some merit to the plaintiffs’ claim (i.e., that it was not just a nuisance suit)? And if there was some merit to the plaintiff’s underlying claim, have the problems that led to the claim been fixed or management just back to business as usual, denying all the while that the plaintiffs’ claim had any basis at all. Either way, this information would make me reconsider my valuation of the insured corporation’s shares. Again, with enough people in the market acting on this information, the corporation’s share price ought to be effected. And, because managers care about share price, this creates an incentive for managers to actually avoid the kind of things that lead to fraud claims. In other words, disclosure, in the context of both underwriting and claims, gives the market what it needs to provide deterrence. If the information disclosed is useful to capital market participants (we obviously believe that it would be), they will use it in ways that create natural incentives for managers to mend their ways. In my view, that’s the big payoff of all of our research in this area.

Thanks again to Kevin for his comments and for the lively debate as this project has evolved.

I would like to thank Professor Griffith for taking the time to write a detailed response to my prior post. I hope other readers will post their thoughts, comments and reactions to Professor Griffith’s observations by using the “Comment” feature in this blog’s right-hand column. I look forward to hearing readers’ reactions to Professor Griffith’s observations.

There are a variety of different ways that the subprime-related litigation might be categorized. For example, the lawsuits might be grouped by type of defendant (as in my prior discussion of lawsuits against the mortgage-backed asset securitzers, here). The lawsuits might also be grouped by type of mortgage-backed asset involved (as in my discussion of lawsuits involving auction rate securities, here). Still another approach might be to look at lawsuits involving certain kinds of mortgages (as in my discussion of Option ARM mortgages, here).

An entirely different way to look at subprime-related litigation might be to follow the developments involving just a single mortgage related financial structure and to trace the litigation in which allegations relating to the structure have been raised. As shown below, just one financial structure has produced significant investor losses and left a spate of litigation in its wake.

The Mantoloking CDO: When the Mantoloking CDO 2006-1 was created in November 2006, it appeared as just one of many collateralized debt obligations (CDOs) listed in the December 4, 2006 Nomura Securities research report (here) describing recent structured finance pricings. As described in the report, the Mantoloking CDO was a $765 million CDO holding asset backed securities (ABS), on which the lead underwriter as Merrill Lynch.

Metro PCS: According to its subsequent court filing, on May 25, 2007, Metro PCS acquired $20 million in auction rate securities “consisting of Class A-2 Senior Priority Floating Notes from the Mantoloking CDO 2006-1, Ltd.” Metro PCS acquired the securities when Merrill Lynch, acting on as the company’s investment advisor, made the investment, as part of what eventually became approximately $134 million of CDO-related auction rate securities in which Merrill invested on the company’s behalf.

In the company’s October 18, 2007 Petition against Merrill Lynch filed in the Dallas County (TX) District Court (here), Metro PCS alleged that Merrill Lynch failed to advise of the company of the intended purchases prior to the acquisition of the Mantoloking securities. The company also alleges that the securities themselves were not authorized under the company’s investment guidelines. The company also alleged that Merrill Lynch had undisclosed conflicts of interest, in that it not only underwrote the initial CDO issuance, but continued to act as the sole dealer for the CDO. The company further alleges that Merrill Lynch itself had significant investments in the CDO and therefore had a vested interest in trying to maintain a market for the CDO’s securities, as a way to protect its investment.

In its February 27, 2008 financial release (here), Metro PCS disclosed that as a result of the latest round of write-downs, it was as of December 31, 2007 carrying the auction rate CDO securities investments for which it paid $134 million at a balance sheet valuation of only $36 million.

The Bear Stearns Hedge Funds: Investors in the Mantoloking CDO apparently also included the two now-bankrupt Bear Stearns hedge funds that are the center of so much controversy (and litigation). The October 22, 2007 Business Week cover article about the hedge fund’s collapse (here) reports that as the hedge funds’ condition and results deteriorated, the hedge funds’ managers “sought out increasingly esoteric bonds and other lightly traded securities that offered higher yields.” As a result, the hedge funds “were big buyers of so-called CDOs-squared – CDOs that invest in other CDOs.” The article reports specifically that “the funds at one time held $135 million of securities issued by the Mantoloking CDO, a CDO-squared.”

On December 19, 2007, when the hedge funds’ largest equity investor, Barclays Bank, sued Bear Stearns Asset Management and the two hedge funds’ individual managers (complaint here), Barclays alleged, among other things, that the hedge funds’ managers had caused the hedge funds “to become a dumping ground for especially risky assets, including numerous CDO-squared securities and other toxic assets.”

MIND C.T.I. Ltd.: The effects of the Mantoloking CDO spread far and wide, its reach including Israel-based communication services provider MIND C.T.I. Ltd.. In its February 27, 2008 filing on Form 6-K (here), MIND reported among other things that the company has as much as $20.3 million invested in asset-backed auction rate securities, on which the company had been unable to obtain third-party valuations, and for which the company may be taking asset-impairment charges in its forthcoming audited financial statements. The company noted that “the complexity of the valuation is derived from the fact that this security is collateralized by 126 structured finance transactions.”

The company’s 6-K also reports that on February 20, 2008, the company had filed a Statement of Claim with the Financial Industry Regulatory Authority (FINRA) and commenced an arbitration “against the international bank and certain employees thereof that invested …funds on behalf of the company.” According to the 6-K, the claim alleges, among other things, that:

the bank was supposed to invest the funds in highly liquid, highly safe, 28-day auction-rate securities, but — without the Company’s authorization — invested the funds in collateralized debt obligations (CDOs). In particular, the claim alleges that the bank invested the funds in a security called "Mantoloking CDO" without telling the Company that this was a CDO investment until after the purchase had already occurred. The claim also describes how, after the fact, the bank advised that the security, which has a stated maturity date in the year 2046, had been rolled "due to failed auction."

According to the 6-K, the FINRA claim includes causes of action for fraud, violation of NASD rules (in particular NASD rules relating to suitability), violation of Section 10 of the ’34 Act, misrepresentation, and breach of fiduciary duty. The 6-K reports that the claim seeks “damages and other relief from all the respondents, including return of all funds plus compensatory and punitive damages.” The 6-K does not identify the “international bank” named in the FINRA arbitration claim.

While the Mantoloking CDO seems to have generated considerable pain for its investors, the CDO was just one of many hundreds of CDOs launched into the marketplace in the last several years. Some of the investors in these other CDOs undoubtedly have experienced some of the same kind of pain the Mantoloking CDO investors have felt, and there likely will be more pain to come. If the sequence of events surrounding the Mantoloking CDO is any indication, the investors in other CDOs can also be expected to pursue litigation to redress their grievances. Just looking at how much litigation the Mantoloking CDO alone has spawned or contributed to, it certainly appears that a formidable amount of CDO-related litigation activity could be involved.

A prior post in which I discuss CDOs squared in much greater length, including the increased risk associated with CDOs squared, can be found here.

Very special thanks to Uri Ronnen of AccountingClues for the links above regarding the Mantoloking CDO.

More UBS Lawsuits: According to news reports (here), on March 5, 2008, Pursuit Partners, a Connecticut-based hedge fund, has initiated a Connecticut state court lawsuit against UBS alleging that the hedge fund made CDO investments last year based on “fraudulent concealment of material information.” The suit alleges that UBS had been in talks with Moody’s and as a result knew that changes in the rating agency’s rating methodology were imminent, yet UBS continued to market the CDOs as if the change would not occur.

The hedge fund contends that when the new rating methodology was announced on October 10, 2007, the $50 million in CDO securities in which the hedge fund has invested were “reduced to junk status,” which triggered a default clause in the underlying derivatives contract, and the hedge fund lost its entire investment. The hedge fund says that “UBS took both sides of a derivatives contract, allowing it to liquidate the CDOs without sustaining a loss of its own.”

The hedge fund’s allegations are similar to the allegations raised against UBS by HSH Nordbank (about which I previously wrote, here), in which HSH Nordbank claimed that UBS had structured a CDO-related transaction so that UBS could profit to the investor’s detriment. HSH Nordbank also claims that UBS’s Dillon Read unit had stuffed the CDO with troubled loans as a way to reduce its own losses.

In addition to the Pursuit Parnters and HSH Nordbank lawsuits, UBS has also been sued by a physician who claims that UBS sold him auction rate securities from a closed end mutual fund, Eaton Vance Limited Duration Funds. According to the March 9, 2008 New York Times article entitled "As Good as Cash Until It’s Not" (here), UBS put all of the doctor’s charitable foundation’s $1.35 million cash in auction rate securities.  The doctor claims that the foundation now can no longer "help prevent AIDS in Africa or provide indigent people with laser vision correction ."

You certainly do start to get the impression that there are a lot of angry investors out there.

Subprime-Related Derivative Complaint: As I documented elsewhere (here), shareholders’ derivative lawsuits were a significant part of the options backdating-related litigation. By contrast, there have been relatively few shareholders’ derivative lawsuits filed in connection with the subprime meltdown. Perhaps the most notable subprime-related derivative lawsuit so far is the action filed last year against AIG, as nominal defendant, and certain of its directors and officers (about which refer here).

On March 4, 2008, an investment fund manager filed a shareholders’ derivative lawsuit in Delaware Chancery Court against Bank of America, as nominal defendant, and certain of its directors and officers. The complaint (here) relates to the company’s January 22, 2008 announcement (here) that it would take a fourth-quarter 2007 write-down of $5.44 billion due to the devaluation of the company’s mortgage-backed securities, primarily CDOs.

The complaint alleges that the company underwrote and invested in CDOs but failed to inform investors of the associated risks, and failed to set aside adequate reserves for possible losses. The complaint also alleges that the company issued misleading disclosures about its exposure to subprime-related losses. The complaint further alleges that the company soft-pedaled its exposure to subprime mortgages.

The complaint alleges that the defendants breached their fiduciary duties, engaged in reckless and gross mismanagement, and wasted corporate assets.

It is not entirely clear why this lawsuit was brought as a derivative lawsuit rather than as a direct claim for damages. As a derivative claim, the lawsuit will be subject to certain defenses, including in particular the demand requirement.

Hat tip to the Courthouse News Service (here) for the copy of the complaint.

Now This: In addition to being the name of a CDO, Mantoloking is also the name of an oceanfront community in New Jersey, population 423 (2000 Census).  According to Wikipedia (here), Mantoloking is "the wealthiest community in the state of New Jersey," and its past residents included Katherine Hepburn and Richard Nixon. The current surfing conditions at Mantoloking can be viewed here.

Add credit default swap counterparty litigation to the growing list of subprime-related litigation categories.

Credit default swaps have, of course, already been drawn into the subprime litigation wave to a certain extent. For example, as I previously noted (here), Swiss Re has been sued in a subprime related securities lawsuit in connection with its write-down in the valuation of certain credit default swaps. And I also previously noted (here) litigation between an institutional CDO investor and the CDO originator where the investor also had credit default obligations for the CDO.

But according to news reports earlier this week (here), Citibank and Wachovia have each been sued in separate lawsuits brought by a credit default swap counterparty. A closer look at the pleadings in the lawsuits suggests we may be seeing a great deal more of this kind of litigation ahead.

First, some definitions.  As explained in Wikipedia (here), a credit default swap is an agreement between two parties under which one party (the seller) agrees, in exchange for a periodic payment, to provide the buyer with protection in the event of a default or other credit event involving an underlying instrument. A credit default swap is like insurance, except that there is no requirement that the buyer actually hold the underlying instrument, so credit default swaps are often used as a means so speculate on interest spreads.

Both Citigroup and Wachovia entered credit default swaps with a hedge fund incorporated in the Bailiwick of Jersey (one of the Channel Islands) The hedge fund, previously known as CDO Master Fund Ltd., is now known as VCG Special Opportunities Master Fund Limited. During 2007, the hedge fund entered two credit default swaps, one with Citibank and one with Wachovia, that are now the subject of litigation.

According to the hedge fund’s January 12, 2008 Amended Complaint against Wachovia (here), on May 21, 2007, the hedge fund entered a $10 million credit default swap with Wachovia in connection with a Class B tranche of a collateralized debt obligation. The hedge fund was to be paid a 2.75% per annum fee for the swap, to be secured by a deposit of $750,000. According to the hedge fund’s allegations, during the course of 2007, Wachovia demanded that increasing amounts of collateral, which by November 2007 cumulated to an amount in excess of the swap’s notional $10 million face value.

The hedge fund kept pace with the demands for additional collateral until the demands exceeded $8,920,000, at which point the hedge fund initiated the dispute resolution mechanisms in the agreement, and ultimately initiated litigation in New York Supreme Court, which Wachovia removed to federal court.

The hedge fund contests that there has been an event of default or any other event that would trigger their payment obligation under the swap. Wachovia for its part submitted a notice of termination, foreclosed on the collateral, and counterclaimed (here) against the hedge fund for the “deficiency.” Wachovia bases its justification for the demands for the increased collateral on the absence of any commercial market for the CDO. The hedge fund’s lawsuit seeks to rescind the swap, on the grounds of fraud and mistake; and also seeks damages for fraud, breach of contract and breach of the covenant of good faith and fair dealing; and unjust enrichment. Wachovia’s counterclaim alleges breach of contract.

The hedge fund’s lawsuit with Citibank is based on more or less the same dispute, albeit in connection with a different credit default swap. According to the hedge fund’s February 14, 2008 complaint (here), the notional value of the Citibank default swap was also $10 million, and Citibank ultimately “extracted” (according to the complaint) collateral of $9,960,000 from the hedge fund. 

There are a number of interesting things about these circumstances. Perhaps the most interesting is that according to the complaints, the hedge fund has approximately $50 million of capital under management. In other words, the notional amount of just these two swap contracts alone represented 40% of the hedge fund’s capital. I am going to go out on a limb and guess that the hedge fund had other contracts too. But whether or not the hedge fund had other contracts, it is hardly surprising that, given its limited capital,  the hedge fund reached a point where litigation seemed like a better option than any further collateral advances; the fund’s managers may have decided they had nothing to lose by fighting

But even more interesting than the hedge fund’s huge vulnerability to just these two transactions is the fact that a couple of major financial players like Wachovia and Citibank were accepting what amounts to insurance from a thinly capitalized pocket portfolio incorporated in the Bailiwick of Jersey. Certainly if they had been placing insurance as such they would never in a million years have transacted with an offshore insurer whose total capital was both so small and such a small percentage of the exposure. Perhaps a belated realization of these shortcomings explains the banks’ demands for additional collateral…

But whatever may have led two of the world’s largest banks to accept guarantees from a small, thinly capitalized hedge fund, these circumstances at a minimum demonstrate something that I suspect we will be reading about a lot more in the coming days – that is, “counterparty risk.”

There are several important things to be recognized about counterparty risk. The first is that it is not a prerequisite to a credit default swap transaction that either party holds the instrument to which the swap relates. The practical consequence of this fact is that the aggregate notional value of all swaps in force far exceeds the value of the underlying instruments. Here’s a number that we all need to contemplate – according to the Wall Street Journal’s March 4, 2008 article (here) about the above-described litigation, the market for swaps totals $45 trillion (that’s trillion with a “t”), an amount that is “comparable to all the bank deposits world wide.” That, my friends, represents a whole lot of counterparty risk.

Another important thing to be recognized about counterparty risk is that, according to the Journal article, hedge funds have in recent years become the predominant players in this market. The Journal says that hedge funds accounted for 60% of the credit default swap trading in high-grade debt and 80% of the low grade debt in the 12 months ending in April 2007.

While many of the hedge funds involved in this marketplace may be better capitalized than the hedge fund described above, the very fact that two banks like Wachovia and Citibank dealt with this fund at all, despite the low ratio of its capital to the notional value of the swap transaction, suggests that a certain amount of business (who knows, perhaps a considerable amount of business) involved hedge funds, and perhaps others, who like the hedge fund described above, will be challenged to respond to calls for additional collateral.

The same turmoil that caused Wachovia and Citibank to call for additional collateral in these transactions is undoubtedly resulting in countless similar communications throughout the marketplace. The longer the disruption in the underlying marketplace continues, the more abrupt the calls will be. The pressures that the principal firms face to protect their own balance sheets adds greater urgency to each of those calls. And the previously hidden but now revealed demon within each transaction motivating those calls is the suddenly frightening prospect of counterparty risk. The particularly frightening aspect of these circumstances is that all of the calls are going out more or less simultaneously – and counterparties with limited capital will find themselves forced against the same wall as the hedge fund described above.

The litigation will be bad. The financial consequences could be worse.

Indispensible Reading: The best way I can think of to end this really depressing blog post is to reward everyone who has read this far and suggest that the best way to put the circumstances described above in context is to read University of Virginia Graduate Business School Professors’ Robert Bruner and Sean Carr’s eminently readable and deeply thought-provoking book, The Panic of 1907 (refer here for more information).

Even though their book describes circumstances from a century ago, there is a chillingly familiar resonance to the events addressed in their book. Among other things, in their efforts to explain how financial panics arise, the professors describe the following factors:

It begins with a highly complex financial system, whose complexity makes it difficult for anyone to know what might be going wrong; by definition, the multiple parts of the financial system are linked, which means that trouble in one institution, city, or region can travel easily and quickly to others. Buoyant growth in the economy makes the financial system more fragile, in part due to the demand for capital and in part due to the tendency of some institutions to take on more risk than is prudent. Leaders in government and the financial sector implement policies that advertently or inadvertently elevate the exposure to risk of crisis. An economic shock hits the financial system. The mood of the market swings from optimism to pessimism, creating a self-reinforcing downward spiral. Collective action by leaders can arrest the spiral, though the speed and effectiveness with which they act ultimately determines the length and severity of the crisis.

Read the book. It is worth reading in and of itself, but under the present circumstances, the book is simply indispensible.

A very grateful hat tip to Floyd Norris, of the New York Times (whose column, here, discussed the Panic of 1907) and whose blog, Notions of High and Low Finance (here), specifically referenced the professors’ book.  

Although there have been some significant exceptions in recent years, it is still generally the case that securities class action settlements are largely funded by D & O insurance. Yet the impact of D & O insurance on the process and ultimate value of securities lawsuit settlements is little understood outside the small world of practitioners in this area. In an excellent March 2, 2008 paper entitled “How the Merits Matter: D & O Insurance and Securities Settlements” (here), Connecticut Law School Professor Tom Baker and Fordham Law Professor Sean Griffith take a closer look at the role of D & O insurance on securities lawsuit settlements.

In this paper, the authors use a technique they have employed in their prior studies of D & O insurance (about which I previously commented here) – that is, in order to understand that actual workings of the D & O insurance industry, they have interviewed a wide variety of involved participants. In this case, they interviewed over fifty persons, including plaintiffs’ attorneys, defense counsel, insurance claims professionals, insurer’s monitoring counsel, and others. As a result of this practical approach, the authors have developed a realistic understanding of the actual settlement dynamics, and what emerges is a perceptive overview of the actual settlement process.

They describe a dynamic where the plaintiffs’ lawyers’ principle objective is to survive the motions to dismiss, and having passed that barrier, to maneuver the case to settlement. The question that often arises is whether the merits of the case matter to the ultimate amount of settlement. However, the absence of any significant trial-based data means there are no “experienced-based” ways to measure the plaintiffs’ likelihood of success on the merits.

The authors found that in the absence of trial-based data, the case settlements are influenced by a number of factors, including, for example, the presence or absence of “sex appeal” or the magnitude of potential damages involved. Case characteristics that might provide “sex appeal” include “SEC investigations, criminal charges, suspicious stock purchases program… and a variety of other case specific facts that cast the defendants’ motives or honesty in a bad light.” On this basis, a number of the individuals the authors interviewed expressed the view that the merits do sometimes matter.

But in addition, there are other “non-merits” factors that may affect the settlement, and “the most significant non-merits factor in the securities class action context is the ability to pay,” and the “willingness to pay that matters is, more often than not, that of the D & O insurer.”

The most significant value of the authors’ research and analysis is their detailed explanation of the role of D & O insurance in the securities lawsuit settlement process. The authors do a commendable job explaining the factors that limit the insurer’s ability to influence the process; the dynamics that drive plaintiffs’ and defendants’ counsel to align against the insurer; the effect that D & O limits and program structure have on the process; and how the other participants’ motivations interact with those of the D & O insurer.

Among the authors’ more provocative conclusions is their suggestion that "plaintiffs and defendants collude to pressure the D & O insurer to settle on terms that may nore reflect the ultimate merits of the claim."

The authors note  that “settlements are largely funded, often entirely, by D & O insurance,” as a result of which “insurance companies are the real parties in interest.” The consequence of this is that “the outcomes of securities class action lawsuits … are driven not by the opinion of a judge or the decision of a jury, but by the consent of the insurers.”

With this dynamic, and in the absence of trial-based data, the sole settlement reference points are prior settlements. Because of this, the authors note, “insurers are bargaining not in the shadow of the law, but in the shadow of prior bargains, at a further remove from decisions by judges or juries on the merits.”

In the end, the authors say that they “cannot draw a strong conclusion about whether the merits do or do not matter.”

They do conclude on the basis of their research that “non-merit factors contribute significantly” and accordingly they explore a couple of alternatives for making the merits matter more: first, they suggest, but sensibly quickly reject, the idea of requiring a specified number or percentage of securities cases to go to trial; and second, they advocate “mandatory disclosure of (1) the amount and structure of a corporation’s insurance coverage, and (2) information on how settlement and defense costs are funded.”

The authors’ advocacy of the compelled disclosure of D & O insurance information is clearly borne of their own frustration at the lack of access, as research academics, to this kind of information. It may be unfair to point out that few others are demanding disclosure of this kind of information. But it does seem fair to point out that even though the authors’ study of settlements was based on interviews with industry practitioners, they do not seem to have reviewed the idea of compelled disclosure with anyone in the insurance industry. If they had, I doubt they would find anyone who would support the idea.

In particular, insurance professionals would like have two areas of concern regarding the compelled disclosure of this information: (1) the impact of the disclosed information on an already complex commercial insurance environment; and (2) the possible impact of the disclosure of insurance information on which companies become lawsuit targets. The authors neither consider nor discuss these practical concerns.

I also wonder about the authors’ suggestion that compelling this information would do anything to make the merits matter more or to deter securities law violations. The authors’ own research shows that a multitude of factors can sometimes affect settlement amounts, including, for example,  the presence or absence of coverage issues or the existence of business considerations that compel a company to throw money at a case to make it go away, even without significant insurer contribution. The disclosure of the kind of information the authors advocate would of course provide research academics with extensive additional information to contemplate, but the possibility that this kind of disclosure would significantly affect the settlement dynamic, much less deter securities law violations, seems remote.  

In any event, the authors’ extensive review of the securities lawsuit settlement process makes a valuable contribution, particularly in their explanation of the role of D & O insurance in that process.

Special thanks to Professors Baker and Griffith for providing me with a copy of their excellent paper.

As I have previously observed (most recently here), life sciences companies remain favored targets of the plaintiffs’ class action securities bar. Even during the two-year securities lawsuit filing lull between mid-2005 and mid-2007, lawsuit filings against life sciences companies continued more or less unabated. Indeed, as I noted here, during 2007, a year in which subprime-related securities lawsuits predominated, pharmaceutical companies were nevertheless among the most frequent sued. 

But while life sciences companies may be frequent securities lawsuit targets, that does not mean that all or even most of those lawsuits are meritorious. The recent dismissals of two securities lawsuits pending against two high-profile life sciences companies underscores the hurdles these lawsuits face.

Guidant: In an Order dated February 27, 2008 (here), Judge Sarah Evans Barker of the United States District Court for the Southern District of Indiana granted defendants’ motion to dismiss the securities class action lawsuit filed against Guidant Corporation and certain of its former directors and officers. Background on the consolidated Guidant securities lawsuit can be found here.

In their consolidated complaint (here), the plaintiffs allege that the defendants knew and intentionally concealed material information including the fact that there were defects in certain Guidant implantable defibrillators and pacemaker devices; that some patients were experiencing serious health issues (and in one instance, death) resulting from those defects; and that disclosure of those defects would have negatively affected both revenue and the company’s then-pending merger with Johnson & Johnson. (The company ultimately merged not with J & J, but with Boston Scientific.) The plaintiffs allege that defendants made false and misleading public statements about the defective devices and the planned J & J merger to keep Guidant’s stock at artificially inflated levels, in violation of Section 10(b) of the ’34 Act and Rule 10b-5 thereunder.

The defendants sought to have the complaint dismissed first on the ground that the complaint failed to satisfy the PSLRA’s heightened pleading requirements for alleging misleading statements, and second, on the grounds that the plaintiffs had not pled particularized facts giving rise to a strong inference of scienter.

The plaintiffs urged that the defendants’ statements were misleading because they “failed to disclose material information about known product defects (and in some cases, because the statements were intended to enhance then-pending merger negotiations with J & J, which would have been jeopardized had Defendants disclosed the defects).” In rejecting this argument, Judge Barker said “there is no affirmative independent duty for a company to disclose all information that could potentially affect its stock price, unless such silence renders an affirmative statement misleading.” She observed that the plaintiffs “have not demonstrated with the requisite particularity how omission of product defect information rendered any affirmative statements misleading.” Judge Barker then went on to note that several of the statements on which the plaintiffs attempt to rely “can be understood as immaterial, non-actionable corporate puffery.”

The plaintiffs also sought to rely on the Guidant’s ultimate product defect disclosures, arguing that the disclosures were partial and contained “half-truths” intended to minimize the impact. Judge Barker found, however, that “it is unclear precisely what facts were omitted from these disclosures that – in Plaintiffs’ opinion – would have more fully and truthfully informed the investing public about Guidant product defects.” Judge Barker went on to note that the plaintiffs “appear to argue” that the company was required “to ‘ring an alarm bell’ of sorts,” but, Judge Barker said, the relevant law “does not require a company to make such a statement – nor does omission of such a statement constitute fraud.”

Judge Barker also found that the plaintiffs had failed to allege sufficient facts to support a strong inference of scienter. The plaintiffs largely relied on the defendants’ stock sales, but Judge Barker found that the plaintiffs “have not demonstrated – as they are required to do – that such sales were dramatically out of line with prior trading practices at times calculated to maximize the personal benefit from undisclosed inside information.” 

Judge Barker further rejected plaintiffs’ arguments that defendants, as a result of their positions within the company, had knowledge of falsity of the company’s statements. Judge Barker found that plaintiffs’ arguments “are entirely conclusory and do not demonstrate with any particularity that any Individual Defendant had knowledge of product defects.” She concluded by noting that “attribution of scienter to Defendants, without particularized allegations indicating how or when Defendants came to possess information about product defaults, constitutes impermissible pleading of ‘fraud by hindsight’.”

Special thanks to a loyal reader for a copy of the Guidant opinion.

Pfizer: In an order dated February 28. 2008 (here), Judge Lewis Kaplan granted the defendants’ motion to dismiss the plaintiffs’ complaint in the consolidated securities class action lawsuit pending against Pfizer and certain of its current and former directors and officers. The complaint alleges that prior to the company’s December 2, 2006 announcement (here) that it was terminating its Phase III trials on torcetrapib, a developmental drug intended to reduce heart disease by raising “good” cholesterol, the company failed to disclose facts that lessened the likelihood that torcetrapib ultimately would prove safe and effective.

The plaintiffs allege that the misleading statements were designed to avoid Pfizer’s erosion of market share due to its impending loss of patent protection by principal Pfizer drugs, and in order to maximize the severance package for Henry McKinnell, the company’s then-Chairman and CEO. Further background regarding the case can be found here. A copy of the consolidated amended complaint can be found here.

In support of their allegations that the defendants’ statements about torcetrapib’s efficacy were misleading, the plaintiffs relied on a variety of sources (including as noted further below, an anonymous blog post). Judge Kaplan found that at most these statements support only an inference that the evidence available during the class period concerning torcetrapib’s efficacy was inconclusive – which the court found would not support an inference that the defendants’ statements were materially misleading. Judge Kaplan found that defendants were “entitled to take an optimistic view” and “need not present an overly gloomy or cautious picture” as long as the public statements “are consistent with reasonably available data.” Judge Kaplan further found that in any event “the conflicting evidence of torcetrapib’s efficacy were part of the total mix of information available to the marketplace.”

In attempting to establish that the defendants’ statements about torcetrapib were misleading, the plaintiffs also cited concerns about the blood pressure side-effects. Judge Kaplan found that the plaintiffs had failed to plead facts supporting the view that the defendants did not believe these side effects were manageable. Judge Kaplan said that “torcetrapib’s ultimate failure is not evidence that the side effects were thought to be unmanageable at the time the alleged miststaments were made. Fraud by hindsight is not sufficient to establish liability under Rule 10b-5.”

Judge Kaplan also found that plaintiffs had failed to establish scienter. The plaintiffs had argued that the defendants had a motive to mislead because Pfizer had a “desperate need to assure the financial community of the existence of a new blockbuster drug.” Judge Kaplan observed that “this is not a unique motive” and “it is a way of saying, in a manner tailored to a pharmaceutical company, something that is true for all profit enterprises – each has an incentive to portray the likelihood that it will continue to prosper.”

Judge Kaplan further noted that with respect to the alleged motive to maximize McKinnell’s severance package that “if scienter could be pleaded on that basis alone, virtually every company in the United States that experiences a downturn in stock prices could be forced to defend securities fraud actions.”

Judge Kaplan granted the motion to dismiss and denied the plaintiffs’ motion for leave to amend, but without prejudice to a renewed motion for leave to amend supported by a proposed amended complaint.

Hat tip to the Courthouse News Service (here) for a copy of the Pfizer decision.

Analysis: On the one hand, it is hard to generalize based only on two case dispositions. But on the other hand, these two high-profile cases in many ways embody the kinds of securities lawsuit allegations that life sciences companies all too frequently are required to confront. The fact is that publicly traded life sciences companies often face significant and unanticipated challenges, of both a regulatory and clinical nature, in the drug development process. And even drugs or devices that have been introduced into commercial distribution can experience unexpected adverse developments. Either kind of setbacks can trigger significant stock price declines.

Even though these kinds of obstacles are fundamental and arguably unavoidable parts of the business and regulatory environment for life sciences companies, all too often these reverses result in securities lawsuits, supported only by allegations that the reverses occurred and therefore company management must have known about the problems from which the reverses arose.

Each of the district court judges in these two cases implicitly recognized these considerations in their rejection of the “fraud by hindsight” allegations. In each case, the courts effectively said that it is not enough to state a claim under the federal securities laws to allege that problems arose and that the defendants must have known about the problems. The courts’ unwillingness to accept fraud by hindsight allegations is significant, as without this recognition, life sciences companies could face significant liability exposures based on the uncertainties and unpredictabilties inherent in their business.

However, because of the stock price volatility that inevitably follows these kinds of adverse developments, life sciences companies likely will continue to attract the unwanted attention of plaintiffs’ securities’ attorneys. The more interesting question is whether these kinds of lawsuits will succeed. The district courts’ recent decisions in the Guidant and Pfizer cases suggest that these kinds of cases may face substantial hurdles in order to survive a motion to dismiss.

A Blog Too Far: One of the interesting twists in the Pfizer lawsuit is the plaintiffs’ unsuccessful attempt to rely on the scribblings of an anonymous blogger to establish the alleged falsity of the defendants’ statements. Judge Kaplan found that “there is no reason to believe that the author of this blog, identified only as RADmanZulu, is likely to have known the relevant facts.” The plaintiffs contended that RADmanZulu was a former Pfizer vice president, but Judge Kaplan said that “the blog post, plaintiffs’ purported source, does not contain any information about RADmanZulu’s identity, and plaintiffs do not articulate any other basis for their belief.” (Some of RADmanZulu’s postings appear in the comments on this blog post, here.)

Moreover, with respect to the specific factual allegations drawn from the blog post, Judge Kaplan noted that “RADmanZulu’s allegation does not claim to be based on personal knowledge and lacks detail that might suggest personal knowledge.” Ultimately, in reaching his conclusion that the plaintiffs had “not pleaded with particular facts sufficient to support their allegation that defendants’ statements were materially misleading,” Judge Kaplan found that the plaintiffs’ factual allegations “are not based on an adequate source or are unsupported by the purported source.”

We here at The D & O Diary choose to believe that Judge Kaplan was not saying that RADmanZulu’s statements were inadequate merely because they appeared on a blog. Rather, it appears that Judge Kaplan found RADmanZulu’s factual allegations inadequate because they were anonymous and unsupported. That is why everyone here at The D & O Diary eschews anonymity and wherever possible tries to provide factual support for our statements.

Bloggers everywhere have a mutual interest in maintaining the credibility of the blogging medium, and while some bloggers will choose anonymity for their own purposes, overall blogging credibility depends on a fundamental sense of personal responsibility with which anonymity may be inconsistent. (We should also add that maintaining anonymity on the Internet is a lot less feasible than some Internet users may casually assume.)

Warren Buffett’s annual letter to Berkshire Hathaway shareholders has become a capitalist cult classic, eagerly awaited each year not only by Berkshire shareholders but also by a broader audience of readers keen to read Buffett’s observations about both his company and the larger business and economic environment. This year’s letter (here), issued after market close on February 29, 2008, does not disappoint, as it brims with commentary on a variety of matters, as well as about the performance of Berkshire itself. But to an unusual extent, this year’s letter may be as noteworthy for what it omits as for what it includes, as I discuss further below. (Full disclosure: I own BRK.B shares, although not nearly as many as I wish I did.)

Buffett’s letter is of course a part of the Berkshire 2007 annual report, and the letter does contain quite a few interesting nuggets about Berkshire. Even though Buffett seemingly goes out of his way to detail his past investing errors (particularly emphasizing his failed Dexter Shoes investment as well as his failure to buy a Dallas TV station), the overall effect is to reinforce Buffett’s astonishing investing success. For example, after documenting his lapses at length, he almost parenthetically mentions the company’s 2007 sale of its 1.3% interest in PetroChina, acquired during 2002 and 2003 for $488 million, for which Berkshire received $4 billion – a staggering 820% gain in approximately five years.

On the other hand, Buffett’s letter also emphasizes that although Berkshire’s insurance businesses had another “excellent year” in 2007 (producing underwriting profit of $3.37 billion, on top of $3.8 billion in 2006), it is “a certainty that insurance industry profit margins, including ours, will fall significantly in 2008.” Buffett’s bases for this conclusion are that “prices are down and exposures inexorably rise.” If natural catastrophes occur, “results could be far worse.” Buffett warns Berkshire’s shareholders “to be prepared for lower insurance earnings during the next few years.”

Buffett also provides a detailed explanation of Berkshire’s growing derivatives exposure. The existence of these contracts in Berkshire’s portfolio may strike some as contradictory, as Buffett has for years railed against derivatives as, among other things, “financial weapons of mass destruction” (as he called them in his 2002 shareholders’ letter). He has bemoaned for years the losses Berkshire sustained in winding down Gen Re Securities derivatives operation (on which Buffett reported in his 2006 letter that Berkshire had sustained a cumulative pre-tax loss of $409 million).

Buffett nevertheless reports in this year’s letter that Berkshire had entered a total of 94 derivative contracts (up from 62 in 2006), apparently in the form of credit default swaps and futures put options on four stock indices. (The stock indices put represents a bet that these indices will close at far-forward dates at levels above where they stood when Berkshire entered the contracts.) While Buffett’s willingness to enter these contracts seems surprising given his long-standing and often-expressed hostility to derivatives generally, he emphasizes that with respect to each of the contracts, Berkshire is holding the cash – which means not only that Berkshire has no counterparty risk, but also that Berkshire has the opportunity to earn investment income in the interim. It is also important to contrast Berkshire’s current portfolio of 94 derivative contracts with the 23,318 contracts that were formerly held by Gen Re Securities. 

Buffett does warn that the mark-to-market accounting required on the derivative contracts “will sometimes cause large swings in reported earnings.” Buffett compares this exposure to Berkshire’s catastrophe insurance exposure and Berkshire’s long-standing willingness to “trade volatility in reported earnings in the short run for greater gains in net worth in the long run.” I have more to say below about Buffett’s comparison between the derivatives portfolio and Berkshire’s catastrophe reinsurance business.

Buffett’s commentaries about Berkshire’s performance are interesting, but Buffett’s letters are valued for far more than their observations on Berkshire’s own performance. Most readers scour Buffett’s letters for his discourse on larger topics, and his most recent letter has much to offer in that regard. In this year’s letter, Buffett returns to some of his familiar themes and also launches into some new topics.

The first familiar theme Buffett sounds relates to problems in the residential mortgage sector. Buffett commented on this topic in last year’s letter, where he decried “weakened lending practices” and mortgage loan structures that subjected borrowers to potentially escalating repayment obligations. In this year’s letter, Buffett has a “told-you-so” tone when he references the “staggering problems” that “major financial institutions” have recently experienced. He comments that “our country is experiencing widespread pain” because of the “erroneous belief” that “house price appreciation” would “cure all problems.” Buffett notes that

As house prices fall, a huge amount of financial folly is being exposed. You only learn who has been swimming naked when the tide does out – and what we are witnessing at some of our largest financial institutions is an ugly sight.

Another recurring theme Buffett revisits in this year’s letter is the U.S. trade deficit and its impact on the dollar’s valuation. In last year’s letter, while reporting on Berkshire’s direct foreign exchange gains, he bemoaned the U.S.’s transformation into a net debtor country as a result of which the country is now shipping “tribute” overseas in the form of an interest income burden that finances what he called U.S. “over-consumption.” Buffett returns to this topic in this year’s letter, specifically commenting on how these circumstances have led to the emergence of sovereign wealth funds:

There has been much talk recently of sovereign wealth funds and how they are buying large pieces of American businesses. This is our doing, not some nefarious plot of foreign governments. Our trade equation guarantees massive foreign investment in the U.S. When we force-feed $2 billion daily to the rest of the world, they must invest in something here.  Why should we complain when they choose stocks over bonds?

In last year’s letter, Buffett did note that Berkshire had “come close to eliminating our direct foreign exchange position,” on which Berkshire had earned roughly $2.2 billion between 2002 and 2006 in investments in 14 different currencies. In this year’s letter, Buffett notes that in 2007 Berkshire had only one direct currency position, in the Brazilian real. Buffett also noted that Berkshire had invested in bonds denominated in currencies other than dollars, citing as a specific example euro-denominated Amazon.com bonds Berkshire purchased in 2002 for $162 million, that were redeemed in 2007 for $253 million (having paid 6 7/8 % interest in the interim).

Yet, Buffett emphasizes, Berkshire’s assets “will always be concentrated in the U.S.,” citing as justification “America’s rule of law, market-responsive economic system, and belief in meritocracy,” which Buffett contends, “are almost certain to produce ever-growing prosperity for its citizens.”

One standard feature of Buffett’s annual letter is a penultimate portion in which he skewers some particular foible of the financial scene. Last year, Buffett targeted the “2-and-20 crowd” of hedge fund “helpers” whose fees enrich themselves at their clients’ expense. This year, in a section of the letter captioned “Fanciful Figures – How Public Companies Juice Earning,” Buffett targets “the investment return assumption a company uses in calculating pension expense.”

Buffett notes that the 2006 average assumed pension return among the 363 S & P companies that have pensions is 8%. Buffett compares this assumed 8% return to the 5.3% average annual increase in the Dow Jones average during the 20th century. In order for the Dow Jones average to continue to grow at just a continued 5.3% annual rate in the 21st century, the Dow Jones average would have to close at 2,000,000 on December 31, 2099. And the companies that are projecting a 10% return “are implicitly forecasting a level of about 24,000,000 on the Dow by 2100.” Buffett characterizes the “helpers” who make these kinds of assumptions as “direct descendants of the Queen in Alice in Wonderland” who has “believed as many as six impossible things before breakfast.”

The reason for these high investment return assumptions, Buffett notes, “is no puzzle,” as they allow CEOS to “report higher earnings,” securing the knowledge that “the chickens won’t come home to roost until long after they retire.”

Having disparaged corporate pension fund accounting, Buffett then moves on to “public pension promises” for which “funding is woefully inadequate.” The “fuse on this time bomb is long,” but the promises that politicians find so easy to make “will be anything but easy to keep.”

Buffett’s annual letter is always entertaining and informative, and this year’s letter is no exception. But it strikes me that there are omissions from this year’s letter, some of which seem to me to be particularly conspicuous.

First, Buffett’s letter makes absolutely no reference to the recent “finite reinsurance” criminal trial that resulted in guilty verdicts against four former Gen Re officials (as well as one former AIG officer). Buffett’s silence on this matter is at one level understandable, as his name did arise in trial testimony, and as news reports suggest (here) that the criminal investigation is continuing. But given the fact that the former CEO and former CFO of Berkshire’s largest subsidiary were found guilty of criminal wrongdoing, Buffett’s lack of any reference to the verdicts (even to say that he could not comment) seems like a significant omission.

Buffett did implicitly draw a seeming contrast between prior Gen Re management (the ones on trial) and current Gen Re management; Buffett said that current management is doing “first-class business in a first-class way” despite “costly and time consuming legacy problems.” Buffett also commented that he learned to his regret that when he acquired Gen Re in 1998, it was no longer the “Tiffany of reinsurers” as it had been previously. Buffett made similar comments in the 2001 and 2002 Berkshire annual reports. (Full disclosure: I was for ten years an employee of a Gen Re operating subsidiary, and for that reason I feel obliged to forebear from any further commentary on these circumstances.)

Second, other than commenting on the mortgage lending industry’s lamentable shortcomings, Buffett provides no further commentary on the subprime crisis. Other insurers reporting their earnings in recent weeks have felt compelled to address both their potential insurance loss exposure to subprime-related liabilities and their companies’ investment portfolio vulnerability to subprime investment losses. On the one hand, Buffett’s credibility is such that if Berkshire had significant exposure in these areas, we would all expect him to have said something about it. On the other hand, given the prominence of these issues, it does not seem too much to have expected him to address these issues, and, again, his failure to comment on these topics seems like an omission.

Third, and related to the topic of subprime, Buffett’s letter makes no reference to Berkshire’s recent high profile entry into the municipal bond insurance business, in the wake of turmoil involving the traditional monoline insurers. While we may perhaps look forward to reading about this development in next year’s letter, this initiative did unfold in late 2007, and I would have expected some commentary about it in this year’s letter, especially given the high profile nature of the move.

But while Buffett did not mention Berkshire’s move into municipal bond insurance, his commentary on the problems public pension funds may face does put Berkshire’s move into providing municipalities with default guarantee protection in an interesting perspective. As Floyd Norris of the New York Times observes on his blog, Notions on High and Low Finance (here), “Why, you might wonder, would Mr. Buffett want to put Berkshire Hathaway into the business of insuring municipal bonds issued by such governments?”

One final apparent omission from Buffett’s letter is that he does not mention Berkshire’s recent acquisition of 3% interest in Swiss Re, or Berkshire’s agreement to assume 20% of Swiss Re’s property and casualty reinsurance business for the next five years. (Refer here for background on these transactions.) On the one hand, the Swiss Re transactions represent 2008 business, and so I suppose we should just be patient and wait until next year’s letter to see what Buffett says about the transactions. But the particular reason that Buffett arguably ought to have discussed the Swiss Re transactions, and in particular the timing of the Swiss Re transactions, is his commentary in this year’s letter about the likely future prospects of the insurance industry. I agree with Buffett that we should all “be prepared for lower insurance earnings over the next few years.” Given these prospects, the timing of the Swiss Re transactions cries out for further explanation.

A Final Observation: Perhaps others might be unwilling to find any relation between the two companies’ respective positions, but I find Berkshire’s increased derivatives exposure somewhat disconcerting in light of AIG’s recent $11.2 billion mark-to-market derivatives portfolio write-down. It may also fairly be argued that Berkshire’s volatility exposure is much smaller than is AIG’s. But after years of Buffett’s lectures about the evils of derivatives, Berkshire’s growing derivatives exposure seem incongruous.

Questions may also be raised about the appropriateness of the analogy Buffett draws between Berkshire’s volatility exposure as a catastrophe reinsurer and the potential volatility from Berkshire’s growing derivatives portfolio. The Wall Street Journal’s March 1, 2008 Breaking Views column (here) put its finger precisely on the problem in its commentary on AIG’s write-down, by pointing out that logical shortcoming of insurers’ putative qualifications to assess and accept risk from these financial instruments:

Insurers say they are experts at managing just this sort of high-severity, low-probability risk. They argue that insuring against floods, hurricanes, and earthquakes has given them peerless expertise in managing it.

But since there’s no market in acts of nature, insuring against them can’t lead to massive mark-to-market write-downs, as financial exposures can. And there’s a big difference between acts of nature, which can be modeled statistically, and the behavior of complex structured-finance instruments packed with assets that have little historical performance data, which frequently confounds statisticians.

The Journal column ends with the observation that “AIG isn’t alone in falling for this false analogy.” 

To be sure, Buffett did not claim that Berkshire’s expertise in underwriting catastrophe reinsurance qualified the company to underwrite derivatives, only that Berkshire’s willingness to accept the volatile results of catastrophe reinsurance was comparable to its willingness to accept volatile impacts from its derivatives portfolio, in exchange for the long run net worth benefits.

In prior posts (most recently here), I have commented on the growing threat of follow-on shareholder litigation ensuing in the wake of Foreign Corrupt Practices Act (FCPA) enforcement actions. A lawsuit recently filed in the United States District Court for the Western District of Pennsylvania represents an entirely different kind of threat arising from allegations of foreign corrupt activities, in the form of a civil action brought directly against the alleged wrongdoer(s) by the alleged victims of the corrupt activity, without any preceding FCPA enforcement action.

On February 27, 2008, Aluminum Bahrain B.S.C. ("Alba") filed a lawsuit against Alcoa, an Alcoa affiliate, and two individuals, one of whom was an officer of an Alcoa affiliate. Alba (owned by an entity in which the Bahrain government has a 70% ownership interest), alleges that the defendants engaged in a 15-year conspiracy involving overcharging, fraud, and bribery of Bahraini officials. A copy of the complaint can be found here. Alba is in the aluminum smelting business, and it has depended since 1990 on Alcoa affiliates for its supply of alumina, a key ingredient in the production of aluminum.

The complaint alleges that beginning in 1993, over $2 billion in payments were funneled through companies (located in Singapore, Guernsey, Switzerland and elsewhere) owned or controlled by a Canadian businessman of Jordanian descent named Victor Dahdaleh, who is named as a defendant in the complaint. A portion of these payments were secretly directed to one or more (unnamed) Bahraini government officials as part of an alleged conspiracy to cause Alba to cede a substantial portion of its equity to Alcoa, to pay inflated prices for alumina, and to corrupt the integrity of senior Bahraini government officials.

A front-page February 28, 2008 Wall Street Journal article describing the complaint (here) states that the lawsuit emerged from Bahrain’s own effort "to root out misbehavior." The Journal also reports that last year Bahrain retained Kroll Associates, which "had uncovered cases of corruption in its state-owned enterprises, and numerous individuals had been arrested."

The FCPA prohibits corrupt payments to foreign officials, but, as pointed out in a post on The FCPA Blog (here) commenting on the Alba case, "there is no private right of action under the FCPA." So enforcement of the FCPA is exclusively the province of the Department of Justice and the SEC. But as the Department of Justice notes in its Lay Person’s Guide to the FCPA, "conduct that violates the antibribery provisions of the FCPA may also give rise to a private cause of action for treble damages under the Racketeer Influenced and Corrupt Organizations Act (RICO) or to actions under other federal or state laws." Alba’s complaint, in fact, seeks to recover damages from the defendants based on their alleged violations of RICO, conspiracy to violate RICO, and for fraud.

The Alba complaint underscores the civil liability exposure that may potentially arise from foreign corrupt practices. While I have previously emphasized the potential threat of lawsuit filed by shareholders against company management as a follow-on to government FCPA enforcement actions, the Alba lawsuit illustrates the threat of direct civil litigation based on foreign corrupt activity without any prior enforcement activity.

This kind of litigation may represent a significant corporate threat for companies engaged in business in countries whose cultures encourage or even seemingly compel this type of corrupt activity. This threat may also extend beyond the corporation and its corporate affiliates to individuals, as well. Only one of the individual defendants named in the Alba lawsuit appears to be an officer of an Alcoa affiliate, but the complaint does also specifically allege that Alcoa’s Chairman and CEO traveled to Bahrain in connection with Alcoa’s efforts to obtain an equity ownership position in Alba. The complaint alleges that this effort was corrupted by the bribery-induced intervention of a Bahraini government official.

Individual directors and offices who find themselves the target of corruption-based civil litigation may face challenges in securing insurance protection in connection with these allegations. Certainly, a determination of liability for the kinds of corrupt conduct alleged in the Alba complaint could run afoul of the typical D & O liability policy’s conduct exclusions. In addition, some D & O policies still retain a commissions and payments exclusions specifically calculated to preclude liability for improper payments. However, individual director or officer defendants could have a strong basis on which to argue that their defense expenses incurred in connection with this kind of litigation should be covered. They could even have a basis on which to try to argue that settlement amounts, in the absence of an actual finding of liability, ought to be covered.

With respect to the corporate entity defendants in these kinds of lawsuits, the picture is slightly different. The typical public company D & O policy provides entity coverage only for claims based on alleged violations of the securities laws. None of the allegations in the Alba complaint arise under the securities laws, so there would not appear to be coverage under the typical public company D & O policy, even for defense expense. Even were entity coverage to extend beyond securities claims (as is the case for many private company D & O policies), the conduct exclusions and any applicable commissions and payments exclusion would preclude coverage for damages imposed on the basis of an adjudication of liability

But in any event, given the increasing globalization of trade and the increasing significance being given to anticorruption efforts in many jurisdictions, the possibility exists for further civil litigation based on alleged corrupt activity, even in the absence of prior enforcement actions. This litigation threat represents another way in which corrupt activity exposure may possibly represent, as I recently wrote, the "next corporate scandal."

Now This:

According to Wikipedia (here), Bahrain is "slightly larger than the Isle of Man, though it is smaller than … King Fahd International Airport" in Saudi Arabia.

New York Subprime Lawsuit Between Two Foreign Banks: As I noted in prior posts (most recently here), mortgage-backed securities investors have already initiated several lawsuits against the investment banks and others that created the securities, some lawsuits filed as individual actions and some as class actions. A mortgage-backed securities investor’s individual lawsuit initiated this week in New York Supreme Court (Manhattan) presents some new twists on this evolving litigation category.

According to the company’s press release (here), on February 25, 2008, German state-owned bank HSH Nordbank AG sued UBS and UBS Securities LLC. The lawsuit relates to one of HSH’s constituent bank’s $500 million investment in 2002 in collateralized debt obligation (CDO) securities known as North Street 2002-4 that were created and managed by the Swiss bank. In its complaint, HSH described itself as a “regional German bank with little familiarity with international structured finance.” As described in a February 25, 2008 Wall Street Journal article (here), the HSH relation with UBS was “more complicated” because in addition to its investment in the CDO, HSH also provided UBS with insurance protection in the form of credit default swaps.  

As reflected in news coverage describing the complaint (here and here), HSH claims that UBS’s now-shuttered internal hedge fund division, Dillon Read Capital Management, selected inferior collateral and used the CDO as a dumping ground for troubled mortgage-backed securities as a way to profit from the credit default swap.

The complaint alleges that during 2007 Dillon Read made substitutions to the “reference pool” of securities linked to the CDO, bringing in securities lined to the ABX index of subprime mortgage instruments, thereby allegedly increasing the CDOs exposure to subprime mortgages “at a time when the outlook on subprime mortgages was already negative.”

HSHS claims that the structure, and in particular its position on the credit default swap, allowed UBS to realize profits of up to $275 million at HSH’s expense. As also reflected in the bank’s February 24 press release (here), HSH alleged that “UBS exploited the structure for its own ends, at HSH’s expense,” and that “UBS evidently regarded North Street 4 not as an investment platform but as an opportunity to defraud HSH.”

HSH alleges that UBS “knowingly and deliberately created a compromised structure.” HSH accuses UBS of breach of contract, fraud, negligent misrepresentation, and breach of fiduciary duty.” HSH is demanding at least $275 million in restitution plus punitive damages.

There are several interesting things about this new lawsuit. The first is that it involved a New York state court lawsuit between two foreign-domiciled companies. This may be due in part to the role played by the now defunct UBS affiliate Dillon Read. But an even likelier explanation is the prospect of the remedies available under U.S. laws, which undoubtedly influenced HSH to pursue its claims in what would otherwise seem to be an inconvenient forum. It is, in any event, singular to find two foreign companies squaring off in a U.S courthouse.

The availability of alternative dispute resolution forums in which the case might also have gone forward may be seen from the fact that UBS itself has already filed a counterclaim against HSH, but (as reflected here), in London rather than in New York. According to news reports, the counterclaim itself has not been made available publicly.

Perhaps the most interesting thing about the HSH lawsuit is the core allegation. The prior lawsuits against the securitizers have essentially been disclosure-based lawsuits, in effect that the securitizers did not provide full or accurate information about the securities they initiated or about the assets underlying the securities. HSH’s complaint also contains these kinds of allegations, but the core of its complaint is not mere misrepresentation, but rather that UBS fraudulently manipulated the transaction structure to its own profit and to the investors’ detriment. These kinds of allegations clearly raise the stakes, and make this case most interesting to watch.

Finally, this is the first subprime-related case of which I am aware between counterparties on credit default swaps. Given the massive volume of credit default swap activity, there is an enormous potential for credit default swap counterparty litigation.

More Auction Rate Securities Write-Downs: In a prior post (here), I discussed the $275 million write-down that Bristol-Myers Squibb took related to its investment in auction rate securities. At the time, I wondered whether other companies would face similar write-downs, with particular interest in the possible impact on companies outside the financial sector.

At least two other nonfinancial companies have now taken their own subprime-backed asset write-downs, in examples that underscore that impact that the breakdown of the auction rate securities market is having on the value of those securities. These write-downs also highlight the fact that the impact of the subprime meltdown extends far beyond the financial sector.

On February 27, 2008, MetroPCS announced (here) in connection with its fourth quarter earnings release that it had recorded a fourth quarter charge of $83 million in unrealized loss on its $134 investment in auction rate securities. Including the company’s $15 million third-quarter write-down, the year-end value of its $134 investment was at $36 million. As I discussed in a prior post (here), MetroPCS has filed a lawsuit against Merrill Lynch in connection with the company’s investment in the auction rate securities. A copy of the complaint can be found here. It is worth noting that company’s reported fourth quarter loss of $47 million included the $83 million impairment charge.

And on February 21, 2008, SBA Communications reported (here) an impairment charge of $15.6 million on three auction rate securities the company held as short term investments. The company’s net loss for the quarter was $24.2 million including the asset impairment charge.

A February 27, 2007 CFO.com article discussing the MetroPCS write-down can be found here. A February 22, 2008 CFO.com article discussing the SBA Communications write-down can be found here.

Got Those Valuation Blues Again, Mama: A February 24, 2008 post on the Re:Balance blog (here) takes a look at the accounting and valuation issues arising out of the subprime crisis, and suggests that the mortgage asset-backed securities valuation problems that are currently emerging are not merely an attribute of the current disrupted market conditions but were inherent in the terms of the instruments at the time they were created.

Jim Peterson, the blog’s author, writes “the more candor and rigor are brought into this year’s audit process, the more stark will be the ultimate concession that the valuation models on which subprime was built were creatures of myth and unreality.” Peterson, who is the accounting columnist for the International Herald Tribune, adds that “the quality of accounting is an effect, not a cause – the level of its virtue and integrity is observable as a mirror held up to commercial society.”