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Publications
Credit Crunch Digest
January 2010
The subprime lending crisis and ensuing credit crunch have resulted in significant losses and numerous lawsuits involving parties to the mortgage lending and securitization process. This digest collects and summarizes recent media reports regarding potential liability, government initiatives, litigation and regulatory actions arising from the subprime mortgage crisis and credit crunch, as well as the increasing number of reported cases of financial fraud.
This issue focuses on recent significant decisions in civil litigation regarding subprime and other high-risk mortgages, auction rate and related securities, the growing number of reported Ponzi and financial fraud schemes around the world, the status of civil, criminal and regulatory actions relating to the Madoff, Stanford and Rothstein Ponzi schemes, and continuing government efforts to ease the economic impact of the subprime crisis and credit crunch.
Litigation and Regulatory Investigations
Fraud and Ponzi Schemes
Government and Regulatory Intervention
Auction Rate Securities
Litigation and Regulatory Investigations
Regulators Scrutinizing Banks That Sold CDOs and Then Bet Against Them
Investigators in Congress, the Securities and Exchange Commission (SEC) and at the Financial Industry Regulatory Authority (FINRA) are reportedly investigating whether banks violated securities laws by creating and selling to clients complex mortgage-linked debt securities that they subsequently shorted. According to Wall Street traders, the mortgage-related instruments, known as synthetic collateralized debt obligations, or CDOs, were peddled by large banks such as Goldman Sachs, Deutsche Bank and Morgan Stanley, which then bet against the same CDOs they had sold. Goldman and other Wall Street firms maintain that there is nothing improper about their transactions, arguing that they typically employ many trading techniques to hedge investments and protect against losses. Investigators are apparently examining whether the firms purposefully selected especially risky mortgage-linked assets to back the securities and set their clients up to lose billions of dollars if the housing market collapsed. (“Banks Bundled Bad Debt, Bet Against It and Won,” The New York Times, December 24, 2009)
Bank Failures May Spur Wave of D&O Lawsuits
As bank failures across the country continue, directors and officers (D&O) lawsuits brought by the FDIC may be on the way. After a bank fails, the FDIC becomes the primary shareholder of the organization and retains the right to sue directors and officers for acts that may have contributed to the bank failure. According to the FDIC, “it has not filed any D&O lawsuits in connection with the bank failures since the crisis began in 2008.” Legal observers note that although no lawsuits have been filed yet, the FDIC is most likely proceeding cautiously in order to avoid creating bad precedents that may doom later cases. The FDIC’s former head of litigation stated that “about half” of the bank failures will see “some director litigation” and that before all is over the litigation “could rival the litigation that occurred in the ’80s and ’90s as a result of the many thrift failures.” (“Legal Tender,” Portfolio.com, January 11, 2010; “Failed Banks: Will the FDIC’s Next Steps Include Litigation?” The D&O Diary, January 11, 2010)
Morgan Stanley Accused by Pension Fund of Defrauding Investors in CDOs
A Virgin Islands pension fund sued Morgan Stanley on December 24, 2009 alleging that the bank defrauded investors by marketing $1.2 billion of risky mortgage-related notes that it expected to fail. The lawsuit accuses Morgan Stanley of collaborating with rating agencies to obtain triple-A ratings for notes sold in 2007 as part of a CDO known as Libertas. The complaint alleges that Morgan Stanley knew that the CDOs were far riskier than the ratings suggested, but the bank was motivated to defraud investors because it was simultaneously shorting the value of the CDOs’ underlying assets. According to the complaint, “Morgan Stanley was betting the entire investment it was promoting would fail.” (“Morgan Stanley Sued Over Failed $1.2 Billion CDO,” Reuters.com, December 29, 2009)
Lawsuit by Baltimore Against Wells Fargo Is Dismissed
A federal court has dismissed a lawsuit filed by the City of Baltimore that accused Wells Fargo of tipping hundreds of black homeowners into foreclosure by singling them out for high-interest subprime mortgages. The court ruled that the city could not prove that the bank’s lending practices had resulted in broad damage to poor neighborhoods. Judge Frederick Motz wrote that the city’s claims were implausible “when considered against the background of other factors leading to the deterioration of the inner city, such as extensive unemployment, lack of educational opportunity and choice, irresponsible parenting, disrespect for the law, widespread drug use and violence.” The court has left Baltimore free to file a more limited complaint detailing specific damages in specific neighborhoods. (“Federal Judge Rejects Suit by Baltimore Against Bank,” The New York Times, January 9, 2010)
Subprime-Related Derivative Lawsuit Settled by Beazer Homes
On December 22, 2009, through its 8-K filing, Beazer Homes announced that it had settled a subprime-related shareholder’s derivative lawsuit filed against the company and many of its officers and directors. Filed in April 2007, the derivative lawsuit accused the defendants of violating federal securities laws by ignoring “red flags” that would have uncovered improper loan practices throughout the company that were materially impacting the company’s financial stability. According to the announcement, the derivative action has been settled with prejudice in consideration for “various enhancements made by the company since 2007 to its corporate governance and disclosure controls, which plaintiff recognizes provides value to the company’s shareholders.” Beazer Homes has agreed to pay the plaintiff’s counsel $950,000. (Beazer Derivative Settlement Notice; “Beazer Homes Settles Subprime-Related Derivative Lawsuit,” The D&O Diary, December 24, 2009)
Huntington Bancshares Subprime Securities Suit Dismissed
On December 4, 2009, Judge Michael Watson of the U.S. District Court for the Southern District of Ohio dismissed with prejudice a securities class action lawsuit filed against Huntington Bancshares and several of its directors and officers. The lawsuit stemmed from Huntington’s $3.3 billion acquisition of Sky Financial Group, Inc. in 2007. One of Sky’s clients had been Franklin Credit Mortgage Corporation, a company that originated subprime mortgage loans. For almost two decades, Sky made loans to Franklin that Franklin then used to finance its mortgage operations. In 2007, Huntington announced that it would be taking an after-tax charge of $300 million because of its loan exposure to Franklin’s deteriorating mortgage portfolio. Following Huntington’s November 2007 announcement, the company’s stock price declined from $16.08 to $14.75. The class action alleged that Huntington misled investors regarding the company’s ability to endure the deteriorating real estate and subprime mortgage market.
In granting the defendants’ motion to dismiss, Judge Watson found that the plaintiffs had failed to adequately allege the necessary elements of falsity and scienter as required under applicable security laws. The court found that the plaintiffs had not presented sufficient information suggesting that Huntington knew of Franklin’s situation prior to Franklin’s own announcement that it was having problems. Additionally, Judge Watson found that the plaintiffs’ allegations failed to establish a strong inference of scienter on the part of the defendants. (“Huntington Bancshares Subprime Securities Suit Dismissed With Prejudice,” The D&O Diary, December 18, 2009; In re Huntington Bancshares Incorporated Securities Litigation, No. 07-CV-1276 (D. Ohio December 4, 2009)
New Study Finds Securities Suits Drop as Credit Crises Ebb
According to a new study conducted by Stanford Law School and Cornerstone Research, U.S. securities fraud lawsuits fell 24 percent in 2009 as litigation related to the credit crunch and subprime mortgage losses began to dry up. Investors filed 169 prospective securities class action lawsuits in 2009, down from 223 in 2008. According to researchers, almost half of the decline stems from the lack of new grounds for suits related to credit losses, while a drop in stock market volatility also contributed to the decrease in stock fraud suits. Joseph Grundfest, a former U.S. Securities and Exchange Commission commissioner who oversees Stanford Law’s Securities Class Action Clearinghouse, reported that “[j]ust about every major financial firm that can be sued has been, so we’ve run out of inventory.” The study also found that 2009 filings were marked by a long delay between allegations of wrongdoing and ensuing legal action, suggesting that law firms are revisiting old cases. (“Securities Suits Drops as Credit-Crunch Cases Dry Up, Study Says,” Bloomberg.com, January 5, 2010; “U.S. Securities Fraud Lawsuits Slide as Crisis Ebbs,” Reuters.com, January 5, 2010; “Latest Securities Study Shows Drop In Class Actions as Credit Crisis Dwindles,” The AM Law Daily, January 5, 2010)
Fraud and Ponzi Schemes
Accused Florida Ponzi Scheme Mastermind to Plead Guilty
On January 6, 2010, authorities disclosed that Scott Rothstein, former Florida lawyer, intends to plead guilty to charges that he ran an investment scheme that defrauded clients out of more than $1 billion. In December, federal prosecutors charged Rothstein with five felony counts, including wire fraud and racketeering, for allegedly running a scheme in which he sold stakes in fictitious legal settlements he claimed his law firm had struck in employment disputes. According to court filings, Rothstein is alleged to have acted with co-conspirators to carry out the $1.2 billion scheme, to create false bank documents that conned investors while providing “gratuities to high-ranking members of police agencies” in order to deflect law enforcement scrutiny. Rothstein, whose license to practice law was revoked last year by the Florida bar, built a prominent 70-lawyer Fort Lauderdale firm that is currently undergoing liquidation in bankruptcy court. (“Rothstein to Revise Plea to Guilty,” The Wall Street Journal, January 7, 2010; “Fla. Lawyer to Plead Guilty in $1 Bln Ponzi Case,” Reuters.com, January 6, 2010)
Federal Prosecutors Investigate Chais’ Role in the Madoff Scheme
On December 11, 2009, U.S. Attorney William Stellmach disclosed that federal prosecutors are conducting a criminal investigation into Stanley Chais’ role in Bernard Madoff’s Ponzi scheme. It is alleged that Chais, a former money manager, served as the “Southern California link” in Madoff’s scheme by attracting wealthy Southern California investors. By the time the public learned about Madoff’s scheme in 2008, Chais and his family had withdrawn $500 million more than they invested with Madoff, and Chais had collected $269 million in fees from investors. In June 2009, the SEC filed a civil suit against Chais alleging that he fraudulently portrayed himself to investors as an “investment ‘wizard.’” In addition, California Attorney General Jerry Brown filed a lawsuit last year seeking to recover funds for Madoff victims. Federal prosecutors argue that the SEC suit could interfere with their investigation and have sought to postpone the SEC suit for six months as they complete their investigation. Chais maintains that he was a victim of Madoff and did not have knowledge of Madoff’s fraudulent scheme. Stellmach disclosed that Chais could be charged with, among other things, conspiracy, mail fraud, wire fraud, securities fraud and money laundering. Stellmach anticipates a decision regarding criminal charges against Chais by June 2010. (“Stanley Chais Target of Federal Criminal Investigation,” Los Angeles Times, December 12, 2009)
Bankruptcy Court Approves Substantial Legal Fees in Madoff Liquidation
On December 17, 2009, the U.S. Bankruptcy Court for the Southern District of New York approved the payment of approximately $21.3 million in legal fees for the law firm charged with liquidating Bernard Madoff’s firm. Additionally, the court approved a payment of approximately $800,000 to Irving Picard, the trustee for Madoff Investment Securities. Picard was appointed by the bankruptcy court to recover Madoff’s business assets and distribute them among the thousands of victims of Madoff’s fraudulent Ponzi scheme. In July 2009, the court approved initial legal fees of $14.6 million and a payment of $760,000 to Picard. The Securities Investors Protection Corporation, which was established by Congress to provide relief to investors when brokerage firms fail, will provide the funds to pay the legal fees and Picard’s fees. (“Legal Fees Mount in Madoff Liquidation,” The Associated Press, December 17, 2009)
PWC Bermuda Seeks Dismissal in Madoff-Related Lawsuit
PricewaterhouseCooper Bermuda (PWC Bermuda) has filed a motion to dismiss a lawsuit filed by investors in two Banco Santandar SA funds. The lawsuit accuses Banco Santandar, Spain’s biggest bank, of failing to protect investors in funds managed by its Geneva-based Optimal Investment Services unit after discovering in 2002 that Madoff deviated from industry standards by acting as custodian of his own funds. In its motion to dismiss, PWC Bermuda says that the lawsuit was amended with a “shotgun approach” to add PWC Bermuda as a defendant, and that the lawsuit does not establish jurisdiction over the Hamilton, Bermuda-based firm or prove that it was responsible for uncovering the Madoff fraud. (“PWC Bermuda Seeks to Drop Suit Over Santandar’s Madoff Losses,” Bloomberg.com, December 31, 2009)
DOJ Investigates Allen Stanford’s Ties to Congress
Since Allen Stanford’s allegedly fraudulent Ponzi scheme was uncovered in early 2009, numerous members of Congress have returned more than $87,000 that they received from Stanford to the court-appointed receiver of Stanford’s firm. In addition, several other members of Congress have turned over money that they received from Stanford to charities. The U.S. Department of Justice is investigating whether lawmakers, who collectively received approximately $2.3 million from Stanford during the past decade, granted Stanford “special favors” that allowed him to operate his massive Ponzi scheme through an offshore bank that he set up in Antigua. In addition to donating funds directly to lawmakers, Stanford spent approximately $5 million in lobbying efforts since 2001 and established a lobbying firm in Washington in 2008. In 2001 and 2002, Stanford successfully pressured members of Congress to defeat bills that would have allowed greater government scrutiny of offshore investments. (“Feds Probe Banker Allen Stanford’s Ties to Congress,” The Miami Herald, December 27, 2009)
Galleon Group Founder Indicted for Insider Trading Case
Two months after the arrest of Raj Rajaratnam, the billionaire founder of hedge fund Galleon Group, a federal grand jury has formally indicted Rajaratnam with 11 counts of securities fraud and conspiracy. Federal prosecutors have also charged Danielle Chiesi, an executive at New Castle Funds LLC, with multiple counts of securities fraud and conspiracy. In the indictment, prosecutors allege Rajaratnam and Chiesi were part of an elaborate network of insiders who illegally shared inside information on companies like Google, Advanced Micro Devices, Hilton Hotels and others, and reaped more than $20 million in illicit profits by trading on confidential information. Although legal experts say that the government’s case, the largest ever insider trading case involving hedge funds, could be hard to prove because of vague laws governing insider trading, prosecutors have powerful evidence in the form of wiretaps, including a phone conversation between Chiesi and several co-conspirators. (“Galleon Chief and Associate Indicted in Insider Case,” The New York Times, December 15, 2009; “Rajaratnam, Chiesi Indicted in New York for Conspiracy, Fraud,” Bloomberg.com, December 16, 2009)
Federal Prosecutors Say Galleon Group Founder Made $36 Million in Illegal Profits
Federal prosecutors in New York filed court papers on January 5, 2009 opposing Galleon Group founder Raj Rajaratnam’s bid for reduced bail. Rajaratnam requested that his bail be reduced to $20 million. Prosecutors are concerned that Rajaratnam may flee to his native Sri Lanka given what prosecutors say is a strong case against him. Rajaratnam is accused of earning millions of dollars from stock trades made with inside information from various corporate officials and hedge fund executives. As part of the filing, prosecutors said that Rajaratnam’s profits in the illegal insider trading scheme were about $36 million, more than double the government’s previous estimate of $17 million. To date, 21 people have been charged in two overlapping insider trading schemes, and six have pleaded guilty. Rajaratnam, who is free on $100 million bail, has denied any wrongdoing. (“Rajaratnam Take Reached $36 Million, U.S. Says,” Bloomberg.com, January 6, 2010)
Government and Regulatory Intervention
Senate Bill on Financial Reform Moves Ahead
On December 23, 2009, Sens. Chris Dodd (D-Conn.) and Richard Shelby (R-Ala.) issued a joint statement saying that Senate discussions in recent weeks between Democrats and Republicans had been “extremely positive.” Currently, the Senate is drafting legislation that could drastically change how U.S. financial markets are regulated. Although both Democrats and Republicans agree on no longer treating firms as “too big to fail” and on strengthening consumer protections, the means to achieve such consumer protections are being debated by both sides. The White House has proposed that a new Consumer Financial Protection Agency be created, an idea Sen. Dodd says is key to any regulatory overhaul. The proposed agency would write, examine and enforce rules related to financial products such as mortgages and credit cards. Republicans have expressed concern with the proposed agency’s powers, and a compromise under consideration would leave enforcement and examination to federal bank regulators. Additionally, Sen. Dodd has proposed creating a single bank regulator to replace the four agencies that now oversee different parts of the banking sector. Sen. Shelby is not in favor of consolidation and would like to keep the FDIC in charge of the oversight of state-chartered banks. A final Senate bill is expected to be finalized by the Senate Banking Committee and introduced to the full Senate in the coming weeks. (“Bipartisan Duo Moves Ahead on Finance Bill,” The Wall Street Journal, December 24, 2009)
FDIC Plans to Increase Staff and Budget
Recent reports indicate that in 2010, the Federal Deposit Insurance Corporation (FDIC) plans to increase its staff by more than 1,600 and its budget by 35 percent in order to effectuate its increasing role in managing bank failures. Prior to the financial crisis that began in 2008, the FDIC traditionally oversaw the placement of failed banks into receivership. During 2009, more than 130 banks failed and the FDIC’s inventory of assets in liquidation has increased to more than $36.8 billion. The FDIC’s chair stated that the FDIC’s budget and staff increases will “ensure that [the FDIC is] prepared to handle an even larger number of bank failures…and to provide regulatory oversight for an even larger number of troubled institutions.” The FDIC expects the number of banks at risk of failing to increase in 2010. In preparation for the increase in bank failures, in 2009, the FDIC began requiring banks to pay additional fees into the FDIC’s deposit-insurance fund. (“Bank Agency Boosts Budget 35 Percent,” The Wall Street Journal, December 16, 2009)
Auction Rate Securities
Investors Seeking Recovery of ARS Losses Get a Second Chance
Courts presiding over three lawsuits brought by investors seeking recovery for losses incurred as a result of investments in auction rate securities (ARS) recently permitted plaintiffs to refile their complaints against Citigroup, Inc., UBS AG, and Raymond James Financial, Inc. after granting defendants’ motion to dismiss. On October 15, 2009, investors filed an amended complaint against Citigroup, which includes additional allegations based on the company’s December 2008 regulatory settlement to illustrate that the company failed to disclose problems with the ARS market despite knowledge that the market was in trouble. In addition, on October 16, 2009, investors filed an amended complaint against Raymond James, which includes an additional 20 pages detailing how the company marketed and sold ARS. Citigroup and Raymond James have renewed their motions to dismiss. Although the court dismissed a consolidated action against UBS after it reached an agreement with regulators for the repurchase of $19.4 billion of ARS, the litigation has been taken over by investors not covered by the regulatory settlement.
Since the $330 billion ARS market collapsed in February 2008, investors sued approximately 19 broker-dealers. SunTrust Banks Inc. and Northern Trust Corp. won permanent dismissals last year and actions against Goldman Sachs were voluntarily dismissed after Goldman agreed to buy back $1.5 billion of ARS. Financial firms have agreed to buy back $61 billion in ARS consisting of 18.5 percent of the original market in an effort to settle regulatory investigations regarding their ARS practices. Analysts estimate that there are still $149 billion in outstanding ARS. (“Auction-Rate Investors Get Redo After Loss of First Fraud Suits,” Bloomberg.com, December 17, 2009)
Missouri Financial Services Firm Reaches Settlement With States
Stifel Nicolaus & Co., a regional financial services firm based in Saint Louis, Mo., reached an agreement on December 28, 2009 to settle lawsuits and other complaints filed by U.S. state members of the North American Securities Administrators Association (NASAA). Pursuant to the agreement, Stifel will buy back ARS from individual investors who bought those securities through Stifel prior to February 2008 when the market collapsed. According to the Missouri Secretary of State, Stifel owes nearly $180 million to approximately 1,200 investors in the United States. Stifel announced in February 2009 a voluntary plan to buy back ARS from individual investors, but according to the recent settlement agreement with the member states of NASAA, Stifel will buy back the ARS six months earlier than it voluntarily planned to buy them back. Stifel will begin partial payments to investors on January 15, 2010. The settlement also requires Stifel to pay a $525,000 penalty to be shared by states participating in the settlement, as well as sums of $250,000 and $25,000 to Missouri and Indiana, respectively, for those states’ costs of investigating the claims against Stifel. (“Stifel Reaches Auction-Rate Securities Settlement,” ABC News, December 28, 2009)
Companies Seek Relief From Investments in Auction Rate Securities
Almost one year after banks reached settlements by which they agreed to buy back approximately $60 billion worth of ARS from individual investors after the market for ARS collapsed in 2008, approximately 400 companies are still seeking to recover billions of dollars invested in ARS. Under the settlement agreements that were negotiated and executed in early 2009, the firms that sold and brokered the sale of ARS to large, sophisticated corporate investors agreed only to use their “best efforts” to help those firms recover their frozen ARS investments. UBS AG is the only bank that agreed to buy back ARS from all its clients, including corporations. Other firms that sold ARS have offered to lend to corporations that bought ARS or to sell the ARS at “steep discounts.” The “best efforts” provision in the settlement agreements only requires the banks to offer “some remedy” to their corporate clients.
Government regulatory agencies, which were involved in negotiating the ARS settlements last year, have only recently begun to pressure brokerage firms to “find a fix” for corporate clients. The New York Attorney General’s office has represented that it will investigate complaints that firms are not using their best efforts to provide relief to their corporate clients, and the SEC has been reviewing complaints and meeting with corporate investors. Some companies that invested in ARS have proposed a plan to the U.S. Department of the Treasury to allow the ARS market to be revived. However, most dealers, investors and borrowers in the market have shown little interest in such a plan. (“Firms Fight Banks Over Billions in Frozen Notes,” The Wall Street Journal, January 2, 2010)
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