On February 27, 2007, plaintiffs’ lawyers’ initiated a securities class action lawsuit in the United States District Court for the Southern District of New York against Swiss Reinsurance Company, the world’s largest reinsurance company, and certain of its directors and officers. A copy of the plaintiffs’ lawyers’ press release can be found here and a copy of the complaint can be found here.

The lawsuit relates to the company’s November 19, 2007 announcement (here) of a 1.2 billion Swiss Franc mark-to-market loss on the two related credit default swaps the company had issued to provide loss protection against certain asset backed securities.

According to the plaintiffs’ attorneys’ press release,

The complaint alleges that during the Class Period, defendants made false and misleading statements about the Company’s financial condition. Specifically, defendants failed to disclose that Swiss Re’s Credit Solutions unit had written two credit default swaps that exposed the Company to great financial risk. In a credit default swap, one party guarantees that a third party borrower will not default on a debt. In this case, Swiss Re guaranteed certain mortgage-backed securities which included some subprime and collateralized debt obligations. When the existence and nature of the credit default swaps was disclosed, Swiss Re’s stock price dropped from CHF97.55 to CHF87.55 (Swiss Francs) the next day.

The complaint particularly emphasizes that the November 19 announcement came just days after the company’s November 6, 2007 third quarter earnings release (here), which did not mention the credit default swap write-off but contained certain representations about the company’s exposure to subprime issues.

There are several interesting things about this lawsuit. While this is not the first lawsuit filed against companies that provided default guarantee protection to subprime securities, the prior companies to be sued in this regard have been the bond insurers whose primary business is providing default protection. As far as I know, the Swiss Re lawsuit is the first lawsuit against a company specifically linked to the issuance of credit default swaps guaranteeing against the default of subprime-related securities. There have been other companies that have announced accounting write-downs in connection with credit default swaps (see, for example, AIG’s recent announcement here), and there undoubtedly will be others – just as there undoubtedly will be other lawsuits in relating to credit default swaps issued on mortgage-backed assets.

The second interesting thing about this suit is who the plaintiff is – the plaintiff is the Plumbers’ Union Local No. 12 Pension Fund, on whose behalf the same law firm (Coughlin Stoia) previously filed a securities class action lawsuit against Nomura Asset Acceptance Corporation and related entities, as discussed in my recent post here. This union fund certainly does seem to have had some remarkably bad luck with its investments as a result of the subprime meltdown. It also seems to have a durable client-attorney relationship with the Coughlin Stoia firm.

The third interesting thing about this lawsuit is that it comes more than three months after Swiss Re’s November 19 announcement. Up to this point, the subprime related lawsuits have followed pretty closely in the wake of disclosure of subprime related accounting adjustments. The delay in filing this lawsuit suggests that the "moping up" exercise may have begun – that is, the process of going back and combing over the prospective claims that might have been missed the first time through. There certainly have been a host of companies who have made fairly significant announcements over the last few months who have not yet been sued. Their date may yet be coming.

It is interesting in another respect that this lawsuit has arisen now. The company got a boost even after write down when on January 23, 2008 it announced (here) that Berkshire Hathaway had taken a 3% interest in the company and would be taking 20% of the company’s property and casualty reinsurance business over the next five years. This seeming validation from the sage of Omaha may not have been enough to mollify at least some investors, apparently.

I have in any event added the Swiss Re case to my running tally of the subprime-related securities lawsuits, which can be found here. The addition of the Swiss Re case brings the total count of subprime securities lawsuits to 47, eight of which have been filed in 2008. As I noted above, the Swiss Re case is to the best of my knowledge the first subprime related lawsuit based on the loss in value of credit default swaps; it seems prudent to assume at this point that there will be more to come.

Everyone Remain Calm: The subprime crisis not only threatens financial losses, it apparently could also hazard a massive loss of life. According to a February 26, 2008 Financial Times article entitled "Banking Crises Shown to Trigger Heart Attack Deaths" (here), between 1,300 and 5,100 people could die if "a significant proportion of banks suffered crises similar to that at North Rock.

Cambridge University researchers studied 40 years of data from the World Bank and the World Health Organizations, and concluded that "system-wide" crises increase average deaths from heart disease an average of 6.4 percent in wealthy countries – and more in developing countries. Researchers warn that a global banking crisis "would kill tens of thousands of people by heart attacks brought on by stress and anxiety." One of the researchers noted that "containing hysteria and preventing widespread panic is important not only to stop these incidents leading to a systemic banking crisis but also to prevent thousands of heart disease deaths."

More About Subprime: Just a reminder that Mealey’s is sponsoring a Subprime-Backed Securities Litigation Conference on March 6, 2008 at the Harvard Club in New York City. The conference is to be chaired by David Grais of the Grais & Ellsworth firm. I will be speaking on the topic of "CDOs, Asset Valuation and the Subprime Litigation So Far." A copy of the conference brochure can be found here.

On February 20, 2008, the United States Supreme Court issued a unanimous holding (here) in LaRue v. DeWolff, Boberg & Associates that ERISA authorizes individual defined contribution plan participants to sue for fiduciary breaches that impair the value of plan assets in the individual’s plan account. This holding could have important implications for future ERISA litigation activity, and the individuals’ claims potentially could present significant insurance coverage issues.

James LaRue is a former employee of DeWolff, Boberg & Associates. He participated in DeWolff’s 401(k) plan. He claims that in 2001 and 2002 he directed DeWolff to “make certain changes to the investments in his individual account” but that DeWolff never made the changes and that this omission “depleted” his interest in the plan by $150,000.

LaRue sued the DeWolff firm and the DeWolff 401(k) plan seeking “make whole” or other equitable relief under Section 502(a)(3) of ERISA, codified as 29 U.S.C. Section 1132(a)(3). (Section 502, which is referred to throughout this post, can be accessed here.)

The district court dismissed LaRue’s complaint on the grounds that LaRue sought money damages, which are not permitted under Section 502(a)(3).

LaRue appealed to the Fourth Circuit, in reliance on both Section 502(a)(2) and 502(a)(3). The Fourth Circuit affirmed the Section 502(a)(3) dismissal on the same grounds as the district court. The Fourth Circuit rejected LaRue’s Section 502(a)(2) claim on the ground that the Supreme Court’s 1985 opinion in Massachusetts Life Ins.Co. v. Russell permitted Section 502(a)(2) claims only on behalf of the entire plan rather than on behalf of any one participant’s individual interest. LaRue sought and obtained a writ of certiorari to the United States Supreme Court.

Associate Justice John Paul Stevens wrote the majority opinion for the court. (There were two concurring opinions, one by Chief Justice Roberts, in which Justice Kennedy joined, and one by Justice Thomas, in which Justice Scalia joined). The majority opinion held that an individual plan participant does have the right to pursue an individual action, notwithstanding the court’s prior holding the Russell case (the majority opinion for which Justice Stevens also wrote). The majority opinion’s analysis turns on the view that, by contrast to the era when ERISA was first enacted and defined benefit plans predominated, “defined contribution plans dominate the retirement scene today.”

The circumstances for an individual participant in a defined benefit plan, Justice Stevens wrote, are quite different than under a defined contribution plan because misconduct relating to a defined benefit plan would not affect any one individual’s plan interest unless the misconduct caused a default of the defined benefit plan itself. Justice Stevens wrote that:

For defined contribution plans, however, fiduciary misconduct need not threaten the solvency of the entire plan to reduce benefits below the amount that participants would otherwise receive. Whether a fiduciary breach diminishes plan assets payable to all participants and beneficiaries, or only to persons tied to particular individual accounts, it creates the kind of harms that concerned the draftsmen of [ERISA’s liability provisions]. Consequently, our references to the “entire plan” in Russell…are beside the point in the defined contribution context.

Accordingly, the court held that Section 502(a)(2) “does authorize recovery for fiduciary breaches that impair the value of plan assets in a participant’s individual account.” The court vacated the Fourth Circuit’s judgment and remanded the case for further proceedings.

Press coverage of the LaRue case has suggested ( for example, here) that the decision may trigger “a raft of lawsuits by employees, particularly as stock market volatility once again is causing havoc with investment accounts.” It may well be that the LaRue decision will lead to a wave of new employee driven litigation. However, employees considering a lawsuit like LaRue’s should consider several things about the Supreme Court’s opinion.

The first is that the only thing LaRue has won is the right to continue his fight. He must now go back to the trial court to substantiate his claim. Justice Stevens specifically noted that “we do not decide whether petitioner made the alleged declarations in accordance with the requirements specified in the plan.”

An additional consideration is that LaRue will still have to overcome potentially significant defenses. For example, Justice Stevens also noted that the court did not decide whether LaRue is “required to exhaust remedies set forth in the Plan before seeking relief in federal court pursuant to Section 502(a)(2).” (Justice Roberts’ concurring opinion has extensive, technical discussion of the “exhaustion of administrative remedies” issue; suffice it to say here that the applicability of the exhaustion requirement is at best unresolved.)

Justice Stevens also said that the court did not resolve the question whether LaRue “asserted his rights in a timely fashion.”

In other words, even though LaRue’s has survived to fight another day, on remand he will face both potentially formidable defenses and daunting evidentiary challenges. Just because an individual may now have the right to pursue an individual claim for 401(k) losses does not mean that the individual has a great claim. Portfolio.com has a more detailed discussion of these issues here, stating among other things that “a ruling that should have been a comfort for the workingman is now a cause of concern.”

But assuming for the sake of argument that the LaRue decision will indeed result in a flood of litigation, these potential claims present a daunting prospect for company 401(k) plan sponsors. The possibility of many small, potentially vexatious individual claims arising out of the company’s defined contribution plan is an unwelcome development.

The prospect of a flood of claims also immediately presents questions about the availability of insurance protection for the claims. I have already had discussions with persons in the insurance industry about how the typical fiduciary liability policy might respond to this type of claim. These discussions have been preliminary only, but one question that has arisen is whether these individual 401(k) claims would trigger the “benefits due” exclusion found in the typical fiduciary liability policy.

While the various carriers’ policies vary, a fairly typical “benefits due” exclusion provides that the carrier “shall not be liable for that part of Loss, other than Defense Costs” that

constitutes benefits due or to become due under the terms of a Benefit Program unless, and to the extent that, (i) the Insured is a natural person and the benefits are payable by such Insured  as a personal obligation, and (ii) recovery of the benefits is based on a covered Wrongful Act.

There are several important considerations presented in this language, but a preliminary (and perhaps preclusive) consideration is whether the “benefits due” exclusion would even apply to the kind of claim LaRue asserted. This preliminary consideration turns on a critical distinction about LaRue’s claim. That is, his claims for breach of fiduciary duty were based on Section 502(a)(2), and he did not assert claims for “benefits due” under Section 502(a)(1)(B). Indeed, in his concurring opinion, Chief Justice Roberts made much of this distinction, and in fact argues that LaRue should have filed his claim as a benefits due claim under 502(a)(1)(B) – which would more clearly have required exhaustion of administrative remedies – rather than as a claim for breach of fiduciary duty under 502(a)(2). A subtle statutory distinction perhaps, but it strongly suggests that the “benefits due” exclusion is irrelevant to an individual’s breach of fiduciary duty claim under Section 502(a)(2).

(For regular practitioners in this area, the foregoing distinction may be obvious, but as I am only an occasional  visitor to this area of the law, the establishment of these critical distinctions requires conscious effort on my part)

Even assuming that the exclusion would be triggered, there are also several additional considerations that would determine how the exclusion would be applied. The first is that the exclusion does not in any event apply to defense expenses. This defense cost carve out from the exclusion could be very significant for companies confronted with a wave of individual employee 401(k) lawsuits. A host of small cases could become very expensive to defend.

The second point about the exclusion is that the exclusion’s coverage carve back at least preserves coverage for natural person insureds with a “personal obligation” to pay benefits due. (ERISA Section 409(a), the statute’s liability provision, specifies that plan fiduciaries are “personally liable”). Natural person fiduciaries are sometimes named as defendants in ERISA lawsuits, but it is noteworthy that LaRue at least named no natural person defendants in his lawsuit. If there were both natural person and entity defendants, and if this exclusion is otherwise triggered, there could potentially be difficult allocation issues for indemnity amounts.

One final note about the insurance issues is that most 401(k) plans are administered by third-party service providers. Plan fiduciaries of course retain their fiduciary responsibilities even if the plan retains a third party administrator, but to the extent insurers foot a loss, they might well seek to subrogate against the third party administrators.

The LaRue decision is still very fresh and reactions are still emerging. One issue that will be particularly interesting to watch, if the predicted flood of individual claims does indeed arise, is whether insurers will respond either through altered terms and conditions (such as requiring increased per claim self-insured retentions as a barrier to low level defense expense) or through changed pricing structures. Dramatic changes seem unlikely in the current environment, but if there really is a flood of claim, insurers may well react.

A particularly good, albeit technical, analysis of the LaRue decision can be found on the Workplace Prof Blog (here). An interesting analysis of the differences between and among the majority and the two concurring opinions can be found on the Boston ERISA & Insurance Litigation Blog (here).

In prior posts (here and here), I noted two subprime securities lawsuit rulings in which defendants’ motions to dismiss were granted with leave to amend. But in a January 4, 2008 order (here) in the Accredited Home subprime-related securities lawsuit pending in the United States District Court for the Central District of California, the defendants’ motions to dismiss were largely denied, except with respect to certain of the outside director defendants’ dismissal motions.

The lead plaintiff in the case is the Arkansas Teacher Retirement System. The corrected consolidated class action complaint can be found here. Background regarding the case can be found here. The complaint names as defendants the company, a subprime-mortgage lender; its mortgage REIT subsidiary; five individuals who served as executives at the company or the REIT; and five individuals who had served as outside directors on the company’s board.

The complaint contains three basic sets of alleged misrepresentations: first, that the company maintained certain loan underwriting standards, when, it is alleged, the standards were in fact lax and were even undermined by the individual defendants; second, that the company maintained adequate reserves and allowances, when, it is alleged, that its reserves in fact did not adequately take into account the deterioration of the company’s mortgage loan portfolio and were even reduced as the portfolio deteriorated, resulting in an overstatement of the company’s earnings; and three, that the company misleadingly accounted for goodwill in connection with its May 2006 acquisition of Ames Investment Corp.

The plaintiffs asserted claims under Section 10 of the ’34 Act (and Rule 10b-5 thereunder); Section 14 of the ’34 Act (and Rule 14a-9 thereunder); and Sections 11, 12 and 15 of the ’33 Act.

In ruling on the motions to dismiss, Judge Marilyn Huff separately assessed the allegations against the various defendants. Judge Huff found that the complaint’s allegations as to the company and the five officer defendants adequately pled that the alleged misrepresentations were false and misleading. In making this finding, the court relied on the “group pleading doctrine,” which the court found properly applied to the officers since the individuals had “direct involvement with the company’s day-to-day affairs and financial statements.”

But Judge Huff declined to extend this finding to the outside directors or to the REIT. Judge Huff said that the complaint “fails to establish any basis for attributing statements” to these defendants. Accordingly, Judge Huff granted the motion to dismiss the Section 10 claims against the outside directors and the REIT.

Judge Huff also found that the complaint adequately pled scienter as to the five officer defendants and the company. She cited the complaint’s allegations that these individuals had “access to periodic reports that included detailed information regarding widespread deviations from company policy” and the allegations from several confidential witnesses that the defendants “actually directed these deviations.” Judge Huff also cited the allegations that the defendants “caused or permitted large decreases in several significant reserve accounts” in violation of GAAP while at the same time aware of the mortgage portfolio’s deterioration.

Judge Huff also found that the plaintiffs had adequately pled materiality, reliance and loss causation. Judge Huff denied the motions to dismiss the Section 14 claim, largely on the same grounds as with respect to the Section 10 claim, although once again she separated out the outside director defendants and granted their Section 14 dismissal motions. She denied the motion to dismiss the ’33 Act claims as well, although she again separated out the outside directors and granted their motion to dismiss the section 12 claims against them .

Special thanks to an alert reader, who felt that if I were going to write about the dismissals granted, I also had to write about the Accredited Home dismissal denial, to which he referred me.

Motion to Dismiss Denied in Comverse Options Backdating Securities Lawsuit: On February 19, 2008, Judge Nicholas Garaufis entered an order (here) denying the defendants’ motions to dismiss the Consolidated Amended Complaint (here) in the Comverse Technology options backdating securities lawsuit. Refer here for background regarding the case.

The motions actually came in the form of an appeal from the prior report and recommendation of Magistrate Judge Ramon Reyes, to whom the court had referred the case.

Significantly, Judge Garaufis reversed the Magistrate Judge’s recommendations in one significant respect. The Magistrate Judge had recommended dismissal of the Section 10(b) claims against the three outside director defendants who had served on the board’s audit and compensation committees. The court found that the three individuals’ “knowledge and experience” coupled with “red flags” evident in the board consent forms, made it “at least as plausible” that the three “were aware of, but ignored a strong likelihood of wrongdoing when the signed the unanimous consent forms.”

The court affirmed the Magistrate Judge’s recommendations in all other material respects.

The plaintiffs’ lawyers’ press release describing the dismissal order can be found here.

I have added the Comverse Technology order to my list of options backdating lawsuit dismissals, denials and settlements, which can be accessed here.

Doomsday estimates of subprime related write-downs of as much as $400 billion, at a time when current Wall Street losses are “only” around $120 billion, beg the question of where the rest of these losses are. Undoubtedly, some part of these as yet unannounced losses will be revealed in many financial institutions’ upcoming earnings releases, as discussed in the February 19, 2008 New York Times article entitled “Wall St. Banks Confront a String of Write-Downs” (here).

But Wall Street woes alone do not encompass the universe of potential losses. As discussed in the February 11, 2008 Financial Times article entitled “The $280bn Question: Where are the Rest of the Subprime Bodies?,” (here), the question that “everyone is trying to work out is where the rest of the bodies are.” The Financial Times article notes that:

Outside Wall Street, suspicions are rife that other institutions are still concealing losses…In particular, there is now rising concern about so-called “buyside” institutions, or entities that have been purchasing mortgage-linked securities in recent years, rather than selling them on. “The problems are moving from the sellside to the buyside – that is where the losses are still to be recognized,” one structured finance expert told a conference in London last week.

There have been some buyside disclosures, the most prominent of which at this point is Bristol-Myers Squibb’s recent $275 write-down of auction rate securities (about which I previously commented here). Whether and to what extent these kinds of write-downs will spread to other nonfinancial companies remains to be seen.

The observers monitoring these developments apparently include plaintiffs’ securities attorneys. A February 19, 2008 Reuters article entitled “Subprime Lawsuits Seen Hitting More Industries” (here) reports that plaintiffs’ attorneys expect that investors lawsuits “likely will spread beyond the financial and housing sectors, as more companies reveal write-downs linked to bad mortgage investments.” The article quotes Salvatore Graziano of the Bernstein Litowitz law firm as saying that “we expect non-real estate companies to start being impacted by this.” He added that his firm has “already gotten a number of inquiries from clients” who are suffering losses from investments they thought were very safe.”

Graziano specifically mentioned the Bristol Myers write-down, commenting that shareholders could potentially bring legal claims against companies that take these kinds of write-downs if the assets were not previously properly valued. He added that “what Bristol-Myers did puts a lot of pressure on the auditors for other companies. That’s why I expect a lot more in coming quarters.”

Graziano also mentions AIG’s recent announcement of potential losses of up to $5 billion in its derivatives portfolio. “I think AIG, without reaching an ultimate conclusion, is a case we’re interested in looking at further.”

More About Auction Rate Securities: In a recent post (here), I discussed the possibility of claims arising from problems connected with auction rate securities. A separate February 19, 2008 Reuters article entitled “Marketing of Auction Rate Securities May Bring Lawsuits” (here) notes that “banks and brokers could face a wave of lawsuits from clients who claim they were not properly told about risks in the now nearly frozen auction rate securities market.” The article quotes Graziano as saying that he has heard “concerns from institutional investors that funds invested in auction rate securities carried an inappropriate level of risk for the kinds of investments they authorized brokers to make.”

Along those same lines, on February 15, 2008, the Miami law firm of Diamond, Kaplan & Rothstein announced (here) that it is “investigating claims involving investment losses in auction rate securities.” The press release specifically mentions broker-dealers that sold auction rate securities, including Lehman Brothers, Goldman Sachs, Merrill Lynch, Citigroup and UBS.

And Then There are the Rating Agencies: One of the recurring themes arising in discussions about subprime issues is the question of the potential liability of the rating agencies (which I discussed most recently here). Jim Peterson at the Re:Balance blog has an interesting discussion (here) of the issues surrounding the rating agencies involvement in the subprime meltdown. Peterson takes the position that the credit rating agencies may not be able to “dodge the bullet” this time. (Peterson is a financial and accounting columnist for the International Herald Tribune.)

Speaker’s Corner: Readers interested in subprime related issues will want to know about two upcoming conferences on the subject. First, IQPC is holding a conference entitled “Subprime and the Credit Crisis” on February 26-27, 2008, in New York City. (agenda here). I will be moderating a panel entitled “Exploring Potential D & O Insurers’ Liability.”

And on March 6, 2008, Mealey’s is sponsoring an event in New York entitled “Subprime-Backed Securities Litigation Conference,” the agenda for which can be found here. I will be speaking on the topic of “CDOs, Asset Valuation and Subprime Litigation So Far.”

The subprime meltdown has already provoked a wave of shareholder lawsuits (as detailed here), in which public company shareholders have alleged subprime-related misrepresentations or omissions that shareholders contend inflated the companies’ share price. But the plaintiffs in an unusual class action securities lawsuit recently filed in Massachusetts state court are not public company shareholders but rather mortgage-backed securities investors who have sued the securitizers who created, issued and underwrote the securities.

In a complaint filed on January 31, 2008 in Suffolk County Mass. Superior Court (here), the Plumbers’ Union Local No. 12 Pension Fund has brought a lawsuit under Section 11, Section 12 and Section 15 of the Securities Act of 1933. The Fund has brought the lawsuit on behalf of itself and the class of investors who purchased mortgage-pass through certificates in connection with Nomura Asset Acceptance Corporation’s July 29, 2005 and April 24, 2006 issuance of hundreds of millions of dollars of the certificates. The defendants in the lawsuit include Nomura Asset and certain of its directors and officers; the eight Delaware trusts in which the underlying mortgage assets were held; and the six investment banks that underwrite the offerings, including Nomura Securities, Goldman Sachs, Merrill Lynch and Citigroup.

The plaintiff alleges that the Registration Statements and Prospectuses issued in connection with the offerings contain false and misleading statements concerning the underwriting standards that would apply to the mortgages to be included; the borrower qualifications to be applied; and the collateral requirements and appraisal standards. The complaint alleges that the actual lending and other practices fell far below the standards described in the Registration Statement, and as a result the assets in the pool “had a much greater risk profile than represented in the Registration Statement.”

The complaint alleges that beginning in the summer of 2007, “the truth about the performance of the mortgage loans that secured the certificates began to be revealed.” The delinquency rates of the underlying mortgages “have skyrocketed.” Several classes of the certificates were downgraded in July 2007 and again in December 2007. The complaint alleges that as a result of the underlying assets’ deteriorating performance, the certificate investors “should receive less absolute cash flow in the future and will not receive it on a timely basis.” In addition, the complaint alleges that the certificates “are no longer marketable at prices anywhere near the price paid” and the investors are “exposed to much more risk with respect to both the timing and absolute cash flow to be received than the Registration Statement …represented.”

There have been prior subprime-related cases brought by mortgage-backed securities investors against the financial institutions that packaged and sold the mortgage instruments. Probably the most prominent example is the case of Bankers Life Insurance Company v. Credit Suisse First Boston, et al., pending in the United States District Court for the Middle District of Florida (amended complaint here). In that case, Bankers Life also alleges misrepresentations in connection with the issuance of certain mortgage-backed pass through certificates. But the Bankers Life case is an individual action, not a class action. In addition, the Bankers Life case does not allege violations of the federal securities laws. Bankers Life alleges negligent misrepresentation, common law fraud, breach of contract, and breach of fiduciary duty, among other things.

UPDATE: An alert reader who prefers anonymity points out another action by a mortgage-backed asset investor against securitizers is the Luminent Mortgage Capital v. Merrll Lynch case pending in the Eastern District of Pennsylvania (complaint here). Luminent alleges that the defendants misled investors concerning certain mortgage loan asset-backed certificates they offered and sold to Luminent. Luminent asserts claims under Section 10(b) of the ’34 Act, Section 12 of the ’33 Act and state law claims of fraud, misrepresentation, negligence, breach of contract and rescission.

So far as I know, the Nomura Asset case is the first class action and the first federal securities case in connection with the current subprime meltdown where mortgage-backed asset investors have sued the mortgage securitizers. (There may well be other federal securities class actions, about which readers are encouraged to let me know .)

UPDATE: Obviously, the Luminent case refered to in the update above asserts claims under the federal securities laws. In addition, an alert reader has brought to my attention another federal securities law class action, captioned as Luther v. Countrywide Home Loans Servicing, originally filed in Los Angeles Ca. County Superior Court, later removed to federal court. The federal court case is now pending in the Central District of California under Civil No. 07-8165. The removal issues are discussed further below. In the Luther case, as in the Nomura Assets case, the plaintiff asserts claims that the defendants omitted material information about the mortgage pass through certificates they sold. The plaintiffs assert claims on behalf of themselves and the class of other certificate purchasers under Sections 11, 12 and 15 of the ’33 Act. Because of the similarities between the Luther case and the Nomura case, the issues surrounding the Luther case are highly relevant to the issues discussed below regarding the Nomura caqse.

The lawsuit is unusual in another respect, which is that it is a federal securities class action lawsuit brought in state court.

The filing of the federal class action lawsuit in state court cannot be written off as the misguided action of some backwater law firm. The plaintiffs’ firms on the complaint include the Coughlin Stoia firm and the Shapiro Haber & Umry firm. I think the only fair assumption is that these lawyers made a deliberate and informed decision to file this case in state court. Which of course begs the question: why?

It is late here at blog central, and there aren’t many people around at this hour with whom I can discuss this question. So I am left to my own meager speculation, which I have set out below. My speculation probably reveals little except my own ignorance of the securities laws. But these are the only reasons I can come up with to explain why this case was filed in state court.

Presumably, the plaintiff intends to rely on the concurrent state court jurisdiction provision in Section 22(a) of the ’33 Act. Whether or not this case is removable to federal court under the Securities Litigation Uniform Standards Act (SLUSA) also seems to be addressed in Section 22(a), which provides that other than with respect to “covered class action” under SLUSA, “no case arising under this title brought in any state court of competent jurisdiction shall be removed to any court of the United States.”

The jurisdictional argument thus turns on whether this is a “covered class action” under SLUSA. The language of SLUSA, codified in Section 16(b) of the ’33 Act, defines a “covered class action” as one “based upon the statutory or common law of any State or subdivision thereof” containing specified allegations in connection with the purchase or sale of a security. The plaintiff will undoubtedly argue that the claims in this case are brought only under federal law, not under the “statutory or common law of any State” and therefore SLUSA does not apply, and the case can therefore remain in state court under the ’33 Act’s concurrent state court jurisdiction.

But even if I am right about this jurisdictional argument (and I will be the first to concede that my jurisdictional analysis could be 100% wrong), that still does not answer the question why the plaintiffs would choose to avail themselves of the state court jurisdiction in the first place, even if it is an available jurisdiction. The best guess I have is that the plaintiffs may intend to argue, under the provisions of the Private Securities Litigation Reform Act (PSLRA) codified into Section 27(a)(1) of the ’33 Act, that the PSLRA applies only to private actions “brought as a plaintiff class action pursuant to the Federal Rules of Civil Procedure.” The plaintiff’s argument may be that because the case was not brought pursuant to the Federal Rules of Civil Procedure, the various provisions of the PSLRA do not apply – for example, the discovery stay or the lead plaintiff provisions. In other words, the plaintiff is proceeding in state court to try to circumvent the hurdles and obstacles of the PSLRA.

An alternative theory is that the plaintiff filed the action in state court to try to circumvent the Supreme Court’s recent holding in the Stoneridge case (about which refer here). But the plaintiff’s claims against the offering underwriters are not based on scheme liability or aiding and abetting theories. The plaintiff is asserting that the various defendants each violated their respective primary duties under the ’33 Act. So it does not appear that the state court filing is an attempt to get around Stoneridge.  

My speculative analysis might be completely wrong. But there has to be some reason why these experienced plaintiffs’ attorneys filed this suit in state court. I have tried to come up with the most plausible theory I could thing of. I welcome readers’ thoughts and commentary, particularly any alternative theories as to why this lawsuit was brought in state court.

UPDATE: As mentioned above, the Luther v. Countrywide Homes case is also a federal securities law action that was filed in state court. Defendants removed the case to federal court and the plaintiffs have moved to remand the case back to state court. The memorandum in support of the plaintiffs’ remand motion can be found here. The plaintiffs argue that the sole basis on which defendants sought to remove the case is the Class Action Fairness Act of 2005, not SLUSA as I had speculated. The plaintiffs argue that Section 22(a) affirnatively forbids the removal of state court ’33 Act cases to federal court and that CAFA did not change that and does not apply to ’33 Act cases. The remand petition will be argued on February 25, 2008.

In any event, it has seemed likely it was only a matter of time before mortgage-backed securities investors pursued federal securities class action lawsuits against the financial institutions that were involved in packaging the subprime mortgages into investment securities. The Nomura Asset case, even though brought in state court, may well portend a whole new category of subprime-related securities litigation. UPDATE: With the added reference to the Luther case, the conclusion that there may be a whole new category of securities cases seems even stronger.

This case poses one other problem for me, which is whether or not to include it in my running tally of subprime related securities lawsuits (which can be found here). While I have faced other definitional issues in maintaining the tally, the one issue that all of the cases have in common is that they were all brought against public companies by the public companies’ shareholders. This case obviously represents something different. Nevertheless, because it is a subprime-related securities lawsuit, I have decided to include in the running tally. Even if I did not forsee all of the kinds of securities litigation that would arise in connection with the subprime meltdown, I did undertake to capture all of the subprime-related securities litigation. So I have added it to the list, even though reasonable minds could disagree over whether it belongs there. UPDATE: I have also added the Luther case to the list as well.

The addition of the Nomura lawsuit to the list brings the total of subprime-related securities lawsuits to 45, including eight so far in 2008. To the extent future developments warrant, I may separately tally the subprime-backed securities investor lawsuits from the shareholder lawsuits. UPDATE: The addition of the Luther case brings the total to 46

As courts have wrestled with the issue whether certain foreign shareholders can act as lead plaintiffs, or indeed can even be included in the plaintiff shareholder class, they have faced an ever-broader array of questions and challenges. The kinds of issues that foreign shareholder litigants present are illustrated in the February 13, 2008 lead plaintiff selection order (here) of Judge Saundra Brown Armstrong of the United States District Court for the Northern District of California in the BigBand Networks securities class action lawsuit. Refer here for background regarding the case.

BigBand, which is based on California, went public on March 14, 2007 (refer here). Its shares trade on Nasdaq. On September 27, 2007, the company announced (here) a revised revenue estimate for the third quarter of 2007. The company’s share price declined and several shareholders filed securities class action lawsuits against the company and certain of its officers and directors as well as the IPO offering underwriters and others.

The two leading contenders for the lead plaintiff role were Gwyn Jones, “a British citizen who resides in the Republic of Cyprus,” and Sphera Fund, an Israeli-based institutional hedge fund investor. The two would-be lead plaintiffs agreed that Jones has the largest financial interest in the case, having sustained losses of $438,617, whereas Sphera sustained losses of $374,889. Sphera nevertheless asserted three grounds on upon which it sought to rebut the presumption that Jones, with the largest financial interest in the  case, was the most adequate plaintiff.

Sphera first argued that in enacting the Private Securities Litigation Reform Act, Congress sought to encourage institutional investors to serve as the lead plaintiff in securities class action lawsuits. Judge Armstrong found however that “a plaintiff’s mere status as an institutional investor does not provide any presumption that the institutional plaintiff is a more adequate plaintiff than an individual investor with a larger financial interest.” Judge Armstrong went on to note that Congress could have created a per se presumption in favor of institutional plaintiffs but did not do so.

Sphera next sought to overcome the presumption that Jones was the most adequate plaintiff by arguing that Jones was subject to a “unique defense.” Sphera argued that the judgment of the U.S. court in a class action securities lawsuit might not be given preclusive effect in Cyprus and that fact was sufficient to overcome the presumption. In making this argument, Sphera drew upon prior holdings in the Vivendi and GlaxoSmithKline cases that the most adequate plaintiff presumption can be rebutted where the presumptive lead plaintiff’s country may not give res judicata effect to a U.S. court’s class action judgment. (Refer here for my prior discussion of the GlaxoSmithKline case, in which the court rejected the lead plaintiff petition of a German investor with the most significant financial interest out of concern that a German court might not enforce the U.S. court’s judgment in the case.)

Sphera’s attempt to challenge Jones broke down on its attempt to substantiate its characterizations of Cypriot law. Judge Armstrong held that “the arguments and evidence presented …are a totally inadequate basis for this Court to form any opinion as to whether Cypriot courts would give binding effects to this Court’s judgments.” Judge Armstrong observed regarding Sphera’s attempt to establish the relevant Cypriot law that

Sphera Fund does not even so much as provide an authenticated version of the Cypriot Civil Procedure Rules, but instead provides only a link to a webpage that is primarily in Greek and appears to contain translations of various Cypriot laws….Moreover, the versions of the rules on this website appear to use idiomatic phraseology that is literally Greek to this Court….The Court therefore has no basis on which to render an informed opinion on this question.

Judge Armstrong went on to note that “on the evidence before this Court,” Sphera’s concern about the enforceability of the U.S. court’s judgment in Cypriot courts “applies equally to Sphera Fund, an Israeli entity as to Jones.” Sphera “provided no specific argument that an Israeli court would give preclusive effect to a securities class action judgment such as may be rendered in this case.” Although relegated to a footnote, a further observation of the court seems particularly relevant to the entire analysis; that is, the court notes that the country of Jones’ citizenship (U.K.) rather than the country of his residence (Cyprus) may be the more relevant consideration, and prior courts have found that U.S. judgments may be preclusive in U.K. courts.

Finally, Sphera’s third argument against the presumption that Jones is the most adequate plaintiff is that Jones is in any event unqualified to serve as lead plaintiff. Sphera’s arguments in this regard are, the court notes, “simply ad hominem attacks on Jones,” which the court dismisses as “sophomoric.”

While there is something more than slightly comical about Sphera’s attempt to present arguments based on Cypriot law in reliance on a partially translated webpage, the spectacle of a court making significant procedural determinations that potentially could affect the interests of absent class members based this kind of process is disheartening. Sphera’s attempt to introduce Cypriot law may have been particularly clumsy, but this kind of spectacle is the almost inevitable absurd extreme to which the courts have been led based on the process of U.S. courts making assessments of foreign laws and of the likelihood that foreign courts would honor U.S. courts’ judgments in class action lawsuits.

Even with respect to jurisdictions such as the U.K. where the law is relatively accessible, the U.S. courts are nevertheless making assumptions that may or may not be valid about what a court in another jurisdiction might do in applying its own laws. And for countries where English translations of relevant legal provisions are unavailable, the entire exercise can simply break down. The inevitably scattershot results are underscored in the BigBand case when the court emphasized that it could not determine one way or another whether the judgment would be enforced in Cyprus or Israel but it was nevertheless proceeding ahead. It is hardly reassuring that the Court more or less acknowledged that it was making its decision in express recognition that it did not know what the relevant law is.

Moreover, with the increasing globalization of investor activity, the prospects for more instances of this kind of exercise, both at the lead plaintiff and at the class certification stage, seems likely. U.S. courts will be increasingly plagued by requirements to discern and make assessments upon the laws of a bewildering array of countries, and make decisions about the substantive rights of aggrieved absent potential class members based on assessments about what a foreign court might do under its law.  

Nor is the inaccessibility of some jurisdictions’ laws the only practical issue involved. For example, in the class certification context, and as Adam Savett pointed out on his Securities Litigation Watch blog, the practical alternative for foreign investors precluded from the shareholder class is for those precluded investors to file individual actions, which is precisely what foreign investors precluded from the Vivendi class have done, as Savett documents here.

The complications arising from foreign shareholder litigants’ involvement in U.S. securities actions defy easy solutions, but it seems increasingly apparent that these issues will continue to arise as foreign investors demonstrate their interest in accessing U.S. courts to seek available remedies under U.S. securities laws. While there are no easy solutions, the current ad hoc case by case method, informed only by U.S. courts’ rough and ready assessments of what the laws of other jurisdictions provide and how those jurisdictions’ courts might apply those laws to a U.S. class action judgment, seems poorly calculated to serve the best interests of absent, aggrieved class members.  

Speakers’ Corner: On March 6, 2008, I will be speaking at the Mealey’s Subprime-Backed Securities Litigation Conference in New York. I am honored to be included with a very illustrious group of speakers, who will be addressing the critical issues in a very comprehensive way. The program is being chaired by David Grais of Grais & Ellsworth. The entire program agenda and other conference information can be found here.

On February 7, 2007, New Century Financial Corp. became the first company to be named in subprime-related securities lawsuit. On January 31, 2008, just short of one year later, Judge Dean Pregerson of the United States District Court for the Central District of California, granted the defendants’ motions to dismiss, but without prejudice and with leave to amend. For background on the lawsuit, refer here. For a copy of the January 31 opinion, refer here.

The plaintiff shareholders had initiated the complaint following the company’s February 7, 2007 announcement (here) that it would be restating its financial statements for the quarters ended March 31, June 30 and September 30, 2006, because of the company’s need to readjust the company’s allowance for “the potential repurchase of loans resulting from early-payment defaults by the underlying borrowers.” The company said that the reserve did not allow for the discounted price the company sustained upon its disposition of repurchased loans. The company’s press release also said that

the company’s methodology for estimating the volume of repurchase claims to be included in the repurchase reserve calculations did not properly consider, in each of the three quarters of 2006, the growing volume of repurchase claims outstanding.

On April 2, 2007, the company announced (here) that it had filed for relief under Chapter 11 of the U.S Bankruptcy Code. The company’s shares ultimately declined more than 97% percent.

On September 14, 2007, the lead plaintiff in the subprime-related securities lawsuit pending against New Century, the New York State Teachers’ Retirement System, filed a consolidated class action complaint. The consolidated complaint names as defendants the company and certain of its directors and officers; the company’s auditor, KPMG, and investment banks that underwrote the company’s June 2005 and August 2006 preferred stock offerings. The consolidated complaint raises allegations against all defendants under Section 11 of the ’33 Act, and against the company and its directors and officers under Section 10 of the ’34 Act.

In assessing the plaintiffs’ allegations, Judge Pregerson said that the complaint “lacks clarity in articulating the grounds for its claims.” The complaint “does not clearly identify the allegedly false statements or which of the factual allegations support and inference that particular statements are false or misleading.” The court attributed these shortcomings to the “lack of organization and somewhat unclear presentation of the allegations.” As a result, Judge Pregerson said, he “has difficulty determining whether plaintiffs have stated a claim.”

Judge Pregerson granted the motions to dismiss but allowed the plaintiffs leave to amend their complaint, by which the plaintiffs may attempt to “resolve deficiencies in the complaint by simple reorganization, revision and clarification of the currently long and at times meandering set of allegations.” The court instructed the plaintiffs that for each of the supposedly false or misleading statements, “the Complaint should identify some facts suggesting that the statement is false or misleading.” The court also directed the plaintiffs to attach to their amended complaint a chart specifying each allegedly false or misleading statement, the supporting factual allegations and the plaintiffs’ conclusion.

Like the prior dismissal of the subprime-related securities lawsuits involving IndyMac (about which refer here), the dismissal in the New Century case is without prejudice. Judge Pregerson’s opinion in the New Century case does not reach the merits, but nevertheless shows great impatience with the plaintiffs’ scattershot pleading approach. (“The Court,” Judge Pregerson observed in a footnote, “should not have to comb through the complaint to identify reasonable inferences from factual allegations to the legal conclusions.”) The plaintiffs have until February 25, 2008 to file an amended complaint. The court has scheduled argument on the updated motions to dismiss on April 21, 2008.

And so the motion to dismiss on the first-filed subprime securities lawsuit might be ready to be decided some 15 months (or more) after the complaint was initially filed. Obviously, at this rate it will take many years before the many subprime related cases have finally ground their way through the system, and before the full impact of the still evolving subprime crisis can be fully assessed.

But it is interesting to reflect, upon review of the events leading up to the New Century lawsuit, and as the subprime meltdown continues to unfold, that as early as the first quarter of 2006, New Century was already experiencing unanticipated loan repurchase requirements resulting from early-payment defaults on subprime loans. The subprime meltdown may seem like a sudden crisis, but has actually already been years in the making and will be even longer in the unfolding. Clearly, the wheels of finance, like the wheels of the law, grind exceeding slow but exceeding fine.

Hat tip to the Class Action Defense Blog (here) for the link to the January 31, 2008 opinion in the New Century case.

Loaded for Bear: The February 15, 2008 Wall Street Journal had an interesting article entitled “Bear Probe May Center on Investor Call” (here) discussing how federal prosecutors’ investigating the collapse of two Bear Stearns hedge funds managed by Ralph Cioffi are examining Cioffi’s statements in an April 25, 2007 conference call with hedge fund investors. Readers interested in this investigation will want to refer back to the December 17, 2007 Business Week article entitled “The Bear Flu: How it Spread” (here) for further background on the circumstances under investigation.

According to the Business Week article, in the April 25 call, Cioffi made statements about a Bear Stearns branded CDO mechanism that Cioffi also managed called “Klio funding.” This mechanism sold commercial paper and other short term debt to money market funds to allow the CDO to buy other higher yielding, longer-term securities. The money market funds were willing to invest because Citigroup agreed to refund their initial stake plays interest (in a so-called “liquidity put”). Citigroup, in turn, drew fees and also was able to sell the Klios mortgage-backed securities of its own.

According to Business Week, the Klio structure spread rapidly as other hedge funds, CDO managers and bankers “followed Cioffi’s lead.” Between 2004 and 2007, Wall Street raised $100 billion through these types of CDOs, “essentially creating a whole new way for industry to finance risky subprime loans.” The article goes on to detail how the Klios offered the Bear Stearns hedge funds a “ready, in-house trading partner,” and that in many months “the Cioffi-managed Klios traded only with the Cioffi-managed Bear funds.” The daisy chain ended in disaster when the subprime loans underlying these investments began to deteriorate. Much of the subprime-related writedowns amongst the investment banks are related to the liquidity puts they provided.

The Journal article reports that in the April 25 call, one participant wondered whether the packaged mortgage securities in the Bear hedge funds were tied to subprime assets. Cioffi reportedly responded that he didn’t have time to teach “CDO 101” or answer basic questions about the securities. It is probably worth observing that the April 25 call came several weeks after New Century had (as noted above) filed for bankruptcy as a result of deteriorating subprime mortgages that were already a problem more than a year before that. The questioner’s inquiry in the April 25 call about subprime was not, as Cioffi’s belittling response suggests, the result of naïveté, but rather well-grounded concern.

Cioffi’s response, although lacking the vulgarity, calls to mind Jeffrey Skilling’s now infamous conference call statement in the fateful final months of Enron. In response to an analyst’s comment that Enron was the only company that releases its earnings statement without a balance sheet, Skilling said “Well, thank you very much, we appreciate that … asshole.” (Refer here for the details about Skilling and the infamous call.)

The comparison may or may not be fair. But every scandal needs a villain, and fair or not, it appears at least based on the news coverage concerning the collapse of the two Bear Stearns hedge funds, that the casting is now complete. It appears that during the current Act of the subprime drama that the role of villain is to be played by Ralph Cioffi, and as with those called to play the villains in prior dramas, his arrogance will be one of the things held against him.

The Backdating Disposition List, Updated: Regular readers know that I have been maintaining a list (accessed here) reflecting all backdating lawsuit dismissals, denials and settlements. I have recently updated the list to add three additional dismissals in options backdating-related derivative lawsuits, two of which are late additions of dismissals I missed last fall. The three dismissals are as follows:

Openwave: On February 12, 2008, the United States District Court for the Northern District of California granted (here) the defendants’ motion to dismiss the plaintiffs’ options backdating related derivative suit, with leave to amend. The court had previously dismissed the plaintiffs’ initial complaint, with leave to amend.The February 12 decision related to the plaintiffs’ amended complaint. The court will allow the plaintiffs another opportunity to amend.

Westwood One: According to the company’s November 1, 2007 filing in Form 10-Q (here), on August 3, 2007, the N.Y. Supreme Court granted the defendants’ motion to dismiss the plaintiffs’ options backdating-related shareholders’ derivative suit. On September 20, 2007, the plaintiffs’ appealed the court’s dismissal and moved for “renewal” under relevant statutes. The appeal remains pending.

Clorox: According to the company’s November 1, 2007 filing on Form 10-Q (here), on October 27, 2007, the plaintiffs voluntarily dismissed their options backdating-related derivative lawsuit in response to the recommendation of the company’s Board’s Audit Committee’s recommendation to the Board that the Board reject the plaintiffs’ suit demand, on the grounds that the suit was not in the best interests of the company.

Special thanks to Adam Savett of the Securities Litigation Watch blog for the information regarding the Westwood One and Clorox dismissals.

Headline of the Week: Still unexplained: why would anyone want TWO dead dogs?: From the February 16, 2007 Financial Times: “Ground-Dog Day as Woman Pays $50,000 to Clone Dead Pitbull” (here).

On February 12, 2008, a plaintiff initiated a securities class action lawsuit in the United States District Court for the Central District of California relating to Morgan Stanley’s subprime-related woes. The complaint (here) purports to be filed on behalf of a class of persons who purchased Morgan Stanley’s shares between July 10, 2007 and November 7, 2007. The gist of the complaint is that Morgan Stanley "failed to disclose its significant exposure to losses related to the declining value of the subprime-related derivatives that the Company traded for its own proprietary account."

The purported class period ends on November 7, 2007, when Morgan Stanley announced (here) that as a result of the decline in "fair value" of "subprime related balance sheet exposures," the company’s revenues for the two months ended October 31, 2007 "were reduced by $3.7 billion." The complaint contends that "analysts and the market" had been "led to believe that Morgan Stanley’s smaller presence in the underwriting of CDOs would not lead to a major write-down."

While the complaint aspires to assert a  number of very serious allegations, the complaint also has a number of features suggesting something other than a highly engineered litigation assault.

First, the complaint does not name the company, its most senior managers, or its directors as defendants. Instead, the sole defendant named in the complaint is one individual, Gary Lynch, identified in the complaint as the company’s Executive Vice President and Chief Legal Officer. (The complaint also alleges that the company’s Internal Audit Department reports to Lynch, but the complaint does not explain the significance of that fact with relation to the complaint’s allegations.)

The complaint refers to no statements that Lynch himself allegedly made, but instead refers only to statements of Morgan Stanley itself. The allegations against Lynch are based solely on his position and responsibilities within the company. However, the complaint does not explain why Lynch should be held liable while none of the other senior company officials, who also obviously held positions of responsibility, are even named as defendants. There are no allegations that Lynch sold his shares of company stock. The scienter allegations are based solely on allegations of Lynch’s supposed actual knowledge of falsity, but there are no specific allegations of which facts he supposedly knew to be false or the basis of plaintiff’s allegations of Lynch’s knowledge. It is not particularly clear why Lynch has been named. Actually, it is not clear at all.

Concerning the company’s own statements, the complaint refers only to the company’s July 10, 2007 and October 10, 2007 filings on Form 10-Q, with respect to each of which the complaint says only that "nowhere within the filing did the company adequately disclose its exposure to losses incurred from trading in its subprime mortgage-backed derivatives, CDOs or the subprime-backed security organizations for which it was responsible."

Second, although the purported class representative’s certification establishes that the plaintiff did indeed pay $17,211 for 340 Morgan Stanley shares, the plaintiff bought his shares on March 14, 2006, well over a year before the commencement of the purported class period. In other words, the purported representative of the class of persons who purchased shares between July 10, 2007 and November 7, 2007 himself bought no shares during that period. The plaintiff will obviously face certain obstacles satisfying the "commonality" requirement, as he is not even a member of the class he purports to represent.

Third, the complaint was filed in the Central District of California. Morgan Stanley’s world famous headquarters are of course located on Broadway, in the heart of New York City. The only apparent connection to California is the plaintiff’s counsel’s office, which is on South Figueroa Avenue in Los Angeles. (According to a search on Google Maps , the distance from the plaintiff’s lawyer’s office to Morgan Stanley’s headquarters is 2,782 miles, a distance that seems metaphorically apt given the attributes of the plaintiff’s complaint.)

But whatever its merits, the complaint does in fact purport to represent a subprime-related class action lawsuit. Accordingly, I have added the case to my running tally of subprime-related lawsuits, which can be found here. As reflected in my tally, the addition of the Morgan Stanley complaint brings the number of subprime-related securities class action lawsuits to 44, and also brings the total number of 2008 subprime-related securities lawsuits to seven. 

It remains to be seen whether another plaintiffs’ firm will follow up on the Los Angles attorney’s salvo and file a more, well, calibrated securities lawsuit, or if this complaint will be the only attempt. It should be noted that Morgan Stanley has already been named in a subprime-related action purportedly brought on behalf of company employees’ under ERISA in connection with their company shares in their defined contribution plans, as described in the plaintiffs’ counsel’s December 18, 2007 press release (here). As noted in my running tally, the Morgan Stanley ERISA suit is one of nine subprime-related ERISA actions.

Subprime: BIgger Than the S & L Crisis?: On February 14, 2008, Navigant Consulting released a report on the 2007 subprime-related litigation (executive summary here). Among other things, the report notes that (including all categories of lawsuits, including borrower suits, bankruptcy actions, employment claims, as well as securities cases) there were 278 subprime-related lawsuits filed in 2007.

Navigant also issued a February 14, 2008 press release (reported here) stating that, by way of  comparison of the subprime litigation wave to the litgation filed in connection with the S & L Crisis, that the 278 subprime lawsuits, all filed in a single calendar year, "already equal one-half of the total 559 actions handled by the RTC over a multiple-year period." The report’s author said that “The S&L crisis has been a high water mark in terms of the litigation fallout of a major financial crisis. The subprime-related cases appear on their way to eclipsing that benchmark.”

The report also notes that, in addition to mortgage bankers and loan correspondents, subprime litigation defendants include "mortgage brokers, appraisers, title companies, homebuilders, mortgage servicers, issuers, underwriting firms, securitization trustees, bond insurers, rating agencies, money managers, public accounting firms and company directors and officers."

The report also notes that "Fortune 100 companies were named in 56 percent of cases" and around "half of all cases were filed in California and New York." Litigation, the report concludes, "is only likely to increase in 2008."

Hat tip to the WSJ.com law blog (here) for the link to the Navigant report.

Subprime Primer: One of the more daunting aspects of the subprime crisis has been the veritable outburst of obscure and confusing terminology. In a recent post, The Sox First blog published a very helpful "Crunch Time Glossary" (here) explaining a long list of the subprime-related terms. My favorite is the Ninja Loan, defined as "a loan given to a person with No Income, No Job, and No Assets." (100% of Ninja loans are now less euphemistically and less colorfully known as "nonperforming.")

A developing breakdown in an obscure corner of the credit-market involving debt instruments called “auction rate securities” could represent the latest threat to emerge from the credit crisis. According to news reports (here and here), the absence of buyers for these securities has caused several recent auctions to fail, forced isuers to abandon their offerings or pay exorbitant rates, and stuck many holders with instruments they did not intend to keep. The declining values for these securities confronts many holders with the prospect of significant balance sheet write-offs, and presents another source of possible litigation arising from the evolving crisis. These circumstances also present more evidence to support my view (expressed most recently here) that the fallout from the credit crisis will ultimately extend far beyond just the financial sector.

 

Auction rate securities are long-term bonds or preferred stock on which the interest rates are reset periodically, usually every seven, 28 or 35 days. The interest rate resets make the instruments more like short-term securities. Holders can also sell the instruments on the reset dates – assuming there are enough buyers.

 

According to a February 13, 2008 article in the Wall Street Journal entitled “Credit Woes Hit Funding for Loans to Students” (here) the market for these securities has “gone into the deep freeze.” Roughly half of the $20 billion in these securities put up for auction on February 12 “failed to generate enough demand to sell.” Problems have been mounting for weeks. According to one commentator in a February 13, 2008 Bloomberg article entitled “Auction-Bond Failures Roil Munis, Pushing Rates Up” (here), “it’s the beginning of the end of the auction rate market.” UPDATE: The lead article on the front page of the February 14, 2008 Wall Street Journal (here) says that this "once-obscure type of bond is now sending shock waves through a broad swatch of the U.S. economy. The February 14 Wall Street Journal also has a separate article entitled "Train Pulls Out of New Corner of Debt Market" (here)

 

According to the Bloomberg article, “investor demand for the securities has declined on waning confidence in the credit insurers backing the debt.”  Whereas in the past, the broker-dealers selling the securities might have intervened to support the market, these dealers are now wrestling with balance sheet issues of their own and can’t take the risk of getting stuck with the securities. These conditions are hitting issuers, such as student lenders, who depend on these instruments to raise funds to loan to students, and municipalities, who are finding the lending costs skyrocketing. The conditions are also hitting investors that purchased the securities in the past and now fund themselves unable to sell, or with interest rate reset mechanisms that are malfunctioning.

 

The February 13 Journal article reports that the size of the auction rate securities market is “$325 billion to $360 billion,” and the Bloomberg article reports that about a third of the 449 companies responding to a May 2007 survey reported that their companies permitted investment in auction rate securities.

 

The turmoil in the market for auction rate securities is already taking a toll on some companies. As I previously noted (here), Bristol-Myers Squibb recently took an impairment charge of $275 million in connection with its investment in auction rate securities. Lawson Software also recently took a charge to adjust for the fair market value on auction rate securities. The February 14 Journal reports that 3M and US Air have also made auction rate securities related accounting adjustments. 

 

As I noted in my prior post discussing the Bristol-Myers write-down, these balance sheet issues potentially affect companies in many different sectors. As I have long said (refer here), before all is said and done, the subprime meltdown is going to be about a lot more than just the financial sector.

 

Indeed, according to a February 6, 2008 CFO.com article entitled “Subprime Woes Just Beginning” (here) Samuel DiPizza, the CEO of PricewaterhouseCoopers, says that the next wave from the subprime mortgage crisis “will flow past lenders and homebuilders and strike nonfinancial U.S. companies with forced writedowns.” DiPiazza specifically referenced the fact that “these securities sit in cash equivalent accounts of industrials; they sit in investment portfolios of pensions. We are having to deal with thousands of companies, not just a handful of big banks.” In a Reuters account of his comments (here), DiPiazza added that a "first wave" of write-downs was likely in the current audit cycle this quarter.

 

Nor does the disruption of the auction rate securities market raise only accounting and valuation issues. There have already been at least two lawsuits brought by auction rate securities investors against investment managers based on soured auction rate securities investments.

 

The first, as reported in the Wall Street Journal (here), was the Texas state court lawsuit (complaint here) brought by Metro PCS against Merrill Lynch. The lawsuit alleges that Merrill invested $133.9 million of the company’s cash in 10 auction-rate securities without appropriate authorization or disclosure and that Merrill later misrepresented the riskiness of the assets and their suitability under the company’s investment guidelines. I previously discussed the Metro PCS lawsuit here.

 

The second lawsuit, first reported Bloomberg (here), involves a FINRA arbitration complaint brought against Lehman Brothers Holdings by Brian and Basil Maher, who claim that Lehman’s investment of $286 million of the brothers’ funds in auction rate securities was inconsistent with the brothers’ stated investment objectives. UPDATE: The February 14, 2008 Wall Street Journal has a front-page article entitled "Debt Crisis Hits a Dynasty" (here) that details how the Mahers earned their fortune and  what happened after they invested a portion with Lehman. The article also describes the Mahers’ arbitration complaint in greater detail.

 

Both of these lawsuits relate to an earlier freeze-up in the market for auction rate securities, in August and September 2007. The more recent market seizure is much more widespread, affects many different levels of securities, and many more investors, including corporate investors. As the PricewaterhouseCoopers CEO’s remarks underscore, many of the companies and investment funds holding these investments face complicated evaluation and accounting issues. Many companies may find themselves compelled (perhaps at their auditor’s insistence) to take asset write-downs or impairment charges. Shareholders and fund investors who may feel they were not fully informed about the balance sheet assets and valuation risks may, like the plaintiffs in the lawsuits cited above, seek legal redress.

 

But in any event, as I have long said, before all is said and done, the subprime litigation wave is going to have spread far beyond just the financial sector.

 

An excellent  February 13, 2008 CFO.com article entitled "Is Your ‘Cash" in Danger" (here) discusses the current state of the auction rate securities market in greater detail (the market is "coming to a screeching halt") and discusses the valuation and accounting implications for companies that hold these securities on the balance sheets. My prior post regarding asset valuation issues in the context of the current credit crisis can be found here.

 

Opt-Out Lookout: As I have tracked the rising significance of securities class action opt-out settlements (most recently here), I have tried to discern whether or not the rash of recent opt-out cases was a temporary phenomenon or more enduring. And while it does not definitively answer the question, the recent analysis on the Securities Litigation Watch blog (here) regarding the opt-outs from the Tyco class action settlement provides some very interesting additional data.

 

According to the SLW, 288 class members excluded themselves from the class settlement (which was finally approved on December 19, 2007). While not all the opt-outs have filed individual actions (yet), so far 88 institutional investors and high net worth individuals have joined in a total of five separate opt-out complaints. The opt-outs include several high profile mutual fund families and investment fund groups, as the SLW details at length.

 

The presence of such a significant number of opt-outs certainly suggests that opting out may prove to be a more enduring phenomenon. On the other hand, the fact that the specific class settlement involved is the Tyco securities case means that we will have to await another day to assess whether the opt-out phenomenon is merely an attribute of the corporate scandals or will become a standard fixture of all securities class action settlements.

 

A Rare Spectacle — Securities Litigation Trials: Another interesting recent phenomenon was the surprising recent coincidence of two securities class action trials, in the JDS Uniphase case and the Apollo Group case. In the latest issue of InSights (here), I take a more detailed look at these two trials and analyze their possible significance.  

 

After nearly two years publishing at its original site on Blogger, The D & O Diary is proud to move into its new home on LexBlog. I hope that all of my readers will welcome and enjoy the new site’s features. The new site should be easier to navigate, and has some added functionality, such as the ability to print individual posts in a printer friendly format (use the little printer icon at the bottom of the post), and the ease of locating popular posts in the (soon to be populated) "Posts of interest" function in the right hand column.

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