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Publications
Credit Crunch Digest
February 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, 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, Dreier 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
Litigation and Regulatory Investigations
Struggling Bond Insurer Sues Credit Suisse Over Mortgage-Backed Securities
Bond insurer Ambac Financial Group Inc. has sued Credit Suisse Securities and its affiliate DLJ Mortgage Capital in New York state court alleging that the two misled Ambac in connection with a pool of more than 2,000 mortgage loans by hiding the fact that many of the borrowers in such pools had little or no ability to repay their loans. The loans were part of a group of mortgage-backed securities (MBS) that Ambac insured in 2007. Ambac alleges that the loans have “defaulted at a remarkable rate” since the transaction closed in March 2007. The lawsuit alleges that a third-party investigator discovered that 80 percent of a sample of loans that were insured under the 2007 transaction were in breach of warranties given to Ambac by DLJ and Credit Suisse. Ambac has already paid $44 million in connection with the transaction. Last month, rival bond insurer MBIA Inc. filed a similar lawsuit against Credit Suisse and its affiliates, including DLJ. (“Ambac Sues Credit Suisse Over Mortgage Securities,” Reuters.com, January 12, 2010; “Ambac Financial Sues Credit Suisse Over Mortgage Security,” The Wall Street Journal, January 12, 2010)
Subprime Securities Lawsuit Against Thornburg Mortgage Partially Dismissed
On January 27, 2010, Judge James Browning of the U.S. District Court for the District of New Mexico granted in part and denied in part the defendants’ motion to dismiss the plaintiffs’ consolidated amended complaint in a purported class action brought against Thornburg Mortgage, Inc. The action arose out of Thornburg’s alleged material misrepresentations and omissions regarding its financial condition and mortgage-related activities, including its exposure to subprime and Alt-A mortgages. Judge Browning dismissed the plaintiffs’ claims under the Securities Act of 1933 (the “Securities Act”) and the Exchange Act of 1934 (the “Exchange Act”) against the Thornburg defendants except Exchange Act claims against Larry Goldstone, Thornburg’s president, chief operating officer and, subsequently, chief executive officer during the relevant time period. In a separate order, Judge Browning also dismissed the plaintiffs’ claims against the offering underwriter defendants, finding that the plaintiffs’ complaint failed to sufficiently allege any material misrepresentations or omissions in the offering documents.
The plaintiffs alleged that Thornburg failed to disclose that its investment portfolio consisted of Alt-A mortgage-backed securities, and that it faced increasing margin calls triggered by the decline in value of the collateral held in its investment portfolio. Increasing margin calls ultimately forced Thornburg to file a voluntary petition for Chapter 11 bankruptcy in May 2009. Although Judge Browning found that the plaintiffs failed to sufficiently allege any material misrepresentations or omissions in any relevant offering documents, the court found that several public statements by Goldstone could be construed as false and misleading. Judge Browning deferred any ruling on the claims against Thornburg pending the bankruptcy proceeding. (“Dismissal Motion in Thornburgh Mortgage Subprime Securities Suit Denied in Part, Granted in Part,” The D&O Diary, February 1, 2010; In re Thornburg Mortgage, Inc. Securities Litigation, No. 07-CV-0815 (D. Ohio January 27, 2010)
Court Grants Rating Agency Defendants’ Motion to Dismiss in Lehman Subprime Lawsuit
On February 1, 2010, Judge Lewis A. Kaplan of the U.S. District Court for the Southern District of New York granted a motion to dismiss filed by rating agency defendants Moody’s and Standard & Poor’s in the multidistrict litigation arising out of the MBS practices of Lehman Brothers Holdings, Inc. The plaintiffs, who purchased MBS issued in August 2005 and August 2006 by certain Lehman Brothers entities, alleged that because the rating agencies determined the composition of the loans that collateralized the securities, the rating agencies “engaged in steps necessary for the distribution” of the securities. Thus, according to the plaintiffs, the rating agencies were “underwriters” as defined by Section 11 of the Securities Act. Judge Kaplan rejected this argument and found that the rating agencies did not qualify as underwriters under Section 11 of the Securities Act because “there is nothing in the complaint to suggest that [the rating agencies] participated in the relevant ‘undertaking’ – that of purchasing the securities at issue …‘from the issuer with a view to their resale.’” Additionally, Judge Kaplan dismissed the plaintiffs’ Sections 12(a)(2) and 15 claims against the rating agencies. (“Rating Agencies Are Not ’33 Act ‘Underwriters,’” The D&0 Diary, February 3, 2010;In re Lehman Brothers Securities and ERISA Litigation, No. 09-MD-2017 (S.D.N.Y. February 1, 2010)
Fraud and Ponzi Schemes
Facing Life in Prison, Rothstein Seeks Shorter Jail Term
On January 27, 2010, Scott Rothstein, the accused mastermind behind an estimated $1.2 billion Ponzi scheme, pleaded guilty in a Florida federal court to five counts of racketeering, fraud and money laundering. Under the terms of Rothstein’s plea agreement, the former Florida attorney admitted using his law firm as a front to perpetrate his scheme of selling phony legal settlements to investors. According to authorities, the investment scheme is likely the largest in South Florida history. Facing a harsh prison term, Rothstein is said to be cooperating with authorities in the hopes of getting a sentence reduction. Rothstein has given authorities detailed information on his crime, including the names of others involved, and the identity of numerous bank accounts and assets purchased with proceeds of the fraudulent scheme. Federal authorities reported that there are other suspects connected to the investment scheme who could be arrested. Rothstein’s sentencing is scheduled for May 6, 2010. (“Scott Rothstein Pleads Guilty, Seeks Shorter Jail Term,” The Miami Herald, January 28, 2010)
Family of Deceased Madoff Investor Agrees to Pay $220 Million to Settle Claims
On January 27, 2010, Irving Picard, the trustee charged with liquidating Bernard L. Madoff Investment Securities LLC (BLMIS) announced in a filing in New York federal court that the family of Norman F. Levy, a New York real estate mogul who died in 2005, agreed to pay $220 million to settle claims arising out of Levy’s profit from Madoff’s Ponzi scheme. Levy purportedly began investing with Madoff in the mid-1970s. According to Picard, the Levy family and related entities, including a charitable foundation operated by the family, withdrew $305 million more from their accounts at BLMIS than they deposited during the six years prior to Madoff’s arrest in December 2008. The agreement between Picard and the Levy family apparently does not require the return of $84 million from BLMIS by the family’s charitable foundation. Unlike the Levy family, many feeder funds and members of Madoff’s family that allegedly earned fake returns on their investments have refused to cooperate, and the trustee has filed “clawback lawsuits” seeking the return of approximately $15 billion from those entities and individuals. (“Madoff Trustee Reports $220 Million Accord With Levy Family,” Bloomberg.com, January 28, 2010)
Madoff’s Brother Faces Criminal Investigation
On January 28, 2010, the U.S. Attorney’s Office in New York confirmed that Peter Madoff, the brother of Bernard Madoff and the former chief compliance officer of BLMIS, is the subject of a criminal investigation regarding his involvement in Bernard Madoff’s fraudulent Ponzi scheme. Peter Madoff also faces civil liability in a case brought by the Lautenberg Foundation, which alleges that it lost its entire $7 million investment with BLMIS. In a letter filed in the U.S. District Court for the District of New Jersey, where the Lautenberg Foundation case is pending, Peter Madoff’s attorney advised that he refuse to answer questions at his deposition in that case because he was informed of the criminal investigation one week before his deposition. (“Bernard Madoff’s Brother Subject of Criminal Investigation,” CNN.com, January 28, 2010)
No U.K. Prosecutions in Madoff Probe
The United Kingdom’s Serious Fraud Office (SFO), which had been investigating Bernard Madoff’s British operation, Madoff Securities International (MSI), has announced that it will take no further action against MSI or its directors. A SFO spokesperson stated that its investigation uncovered “insufficient evidence to provide a realistic prospect of conviction” of the directors of MSI. The SFO, however, will continue to investigate “wider aspects” of Madoff’s fraud and to work with agencies outside the United Kingdom, which “may give rise to offending in the U.K.” (“Bernard Madoff Prosecutions Dropped by SFO,” BBC News, February 2, 2010)
Federal Court Dismisses SEC Case Against Executives Accused of Helping Madoff
A federal court in New York has dismissed fraud claims brought by the Securities and Exchange Commission (SEC) against three Cohmad Securities Corp. executives accused of helping Madoff conduct his estimated $65 billion Ponzi scheme. On February 2, 2010, Judge Louis Stanton dismissed the fraud claims against Cohmad Chair Sonny Cohn, Chief Operating Officer Marcia Cohn and former Vice President Robert Jaffe. The defendants worked with Madoff for many years and referred numerous clients to Madoff’s firm. In dismissing the fraud action, Judge Stanton found that “one who conducts normal business activities while ignorant that those activities are furthering a fraud is not liable for securities fraud.” The ruling leaves the SEC the opportunity to pursue possible civil fines against the defendants. (“SEC Case Against Madoff Associates Dismissed,” Reuters.com, February 2, 2010)
Madoff Trustee Looks to Canada to Uncover Madoff Assets
Irving Picard has asked a U.S. Bankruptcy Court to allow him to hire a Montreal law firm to assist in finding Madoff assets believed to be in Canada. In a recent court filing, lawyers for Picard asked for the court’s approval to hire Canadian firm Kugler Kandestin as special counsel to the trustee. The trustee has not divulged what the Canadian assets may be, or how much they may be worth. Picard previously reported that he has located assets and businesses “of interest” in 11 places, including, Britain, Ireland, France, Luxembourg, Switzerland, Gibraltar, Bermuda, the British Virgin Islands, the Cayman Islands and the Bahamas. (“Madoff Trustee Seeking Assets in Canada,” The Globe And Mail, January 12, 2010); ("Madoff Assets Located in Canada, Lawyers Needed, Trustee Says," Bloomberg.com, January 11, 2010)
Court Expected to Approve Proposed Settlements in Dreier Case
In a memorandum dated January 29, 2010, Judge Jed S. Rakoff of the U.S. District Court for the Southern District of New York indicated that he intends to approve proposed settlement agreements between the estates of Marc Dreier and Dreier LLP and hedge funds that purchased promissory notes from Dreier. Dreier was arrested in late 2008 and pleaded guilty in May 2009 to charges of securities fraud, wire fraud and money laundering in connection with a scheme to defraud hedge funds of nearly $400 million. Federal prosecutors and the trustees of the Dreier and Dreier LLP bankruptcy estates asked Judge Rakoff to approve the proposed settlements, whereby the trustee for Dreier LLP agreed to refrain from challenging the government’s attempt to collect certain forfeited funds and prosecutors agreed to transfer certain property to the trustee and refrain from pursuing proceeds from avoidance actions brought by the trustee. (Judge Set to Sign Off on Dreier Settlements, New York Law Journal, February 2, 2010)
Trial Begins Against Former Stanford Employees Accused of Shredding Records
On February 1, 2010, the criminal trial against Bruce Perraud and Thomas Raffanello, former employees of Stanford Financial Group’s Fort Lauderdale office, commenced in the U.S. District Court for the Southern District of Florida. Perraud and Raffanello are accused of conspiring to shred business records sought by the SEC. According to the indictments against Perraud and Raffanello, a federal court in Dallas issued an order on February 16, 2009, after the SEC initiated its lawsuit against R. Allen Stanford mandating that “anyone who had notice of the order was barred from disposing of or destroying company records.” Perraud and Raffanello allegedly arranged for documents at Stanford Financial’s Fort Lauderdale office to be destroyed by February 23, 2009. Counsel for Raffanello and Perraud challenged the applicability of that order to Raffanello and Perraud by asserting that the order is “fatally flawed.” (“Stanford Workers Accused of Shredding Go to Trial (Update 1), Bloomberg BusinessWeek, February 1, 2010)
Government and Regulatory Intervention
Obama Administration Proposes Banking Reforms
President Barack Obama’s economic advisors submitted a plan to the president at the beginning of the year to regulate both the size and activities of large U.S. banks, and President Obama announced his support of the proposal on January 21, 2010. The Obama administration believes that the proposed regulations will curb potential sources of future risk in the banking system although there is debate among members of the administration regarding whether the proposed regulations would have forestalled the current financial crisis. Under the Obama administration’s proposal, bank holding companies would be prohibited from owning, investing in or sponsoring hedge funds or private equity funds or engaging in proprietary trading. The breadth of the administration’s definition of proprietary trading remains unclear, but administration officials have stated that banks would not be allowed to use their own capital for “trading unrelated to serving customers.” In addition, the Obama administration’s proposal calls for placing a cap on the market share of liabilities held by any one bank. The regulation would be similar to a regulation in effect since 1994 that limits the share of insured deposits held by any one bank to 10 percent. The administration expects the regulations to apply to foreign banks that have large American operations, but it is not clear whether foreign governments will endorse the proposal. (“Obama’s Move to Limit ‘Reckless Risks’ Has Skeptics,” The New York Times, January 22, 2010)
Financial Reform Bill Stalls in Senate
On February 5, 2010, Sen. Christopher Dodd, D- Conn., chair of the Senate Banking Committee, announced that talks with his Republican counterpart regarding the proposed financial reform bill had reached an “impasse.” According to reports, Republican Sen. Richard Shelby of Alabama and Sen. Dodd appear to disagree about the creation of a consumer protection agency to regulate financial products such as mortgages and credit cards. In addition, new constraints on banks’ risk-taking proposed by the Obama administration last month have also been controversial, complicating negotiations. (“Hopes Fade For Bipartisan Financial Reform Bill,” Financial Times, February 5, 2010); ("Senate Financial Services Reform Efforts Stall," Business Insurance, February, 5, 2010)
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