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Publications
Credit Crunch Digest
April 2009
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 and announcements 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 the developing civil litigation and regulatory and criminal actions relating to subprime and other high-risk mortgages, the securitization of such loans and the collapse of the auction rate securities market, the growing number of reported Ponzi schemes and related litigation, and ongoing government efforts to ease the economic impact of the subprime crisis and credit crunch, including newly proposed programs aimed at removing toxic assets from bank balance sheets and a proposed broad overhaul of financial regulations.
Litigation and Regulatory Investigations
Ponzi Schemes
Auction Rate Securities
Government and Regulatory Intervention
Litigation and Regulatory Investigations
‘Surge of Prosecutions’ of Financial Fraud Expected
In response to rising public anger, federal and state authorities are preparing to file a “surge of prosecutions of financial fraud.” The “public’s zeal for Wall Street pelts is high” and Congress is increasing pressure on criminal and regulatory authorities to take action. As a result, there appears to be growing momentum to prosecute executives involved in the mortgage crisis as “the environment for corporate fraud cases could scarcely be more inviting.” Prosecutors have already begun indicting dozens of loan processors, mortgage brokers and bank officers, and the Justice Department is apparently considering whether to form a task force to centralize the effort or allow state attorneys general to develop cases on their own. While prosecutors have had a relatively easy time prevailing in criminal actions against individuals and entities “at the low end of the mortgage transaction ladder” such as appraisers and mortgage brokers, the government will likely have a more difficult time obtaining convictions against Wall Street executives. (“Financial Fraud Is Focus of Attack by Prosecutors,” The New York Times, March 12, 2009)
Impac Subprime Securities Action Dismissed
A California federal court judge on March 9, 2009 dismissed with prejudice a third amended complaint in a purported securities class action against Impac Mortgage Holdings. The complaint generally alleged that Impac misrepresented its underwriting standards with respect to Alt-A loans. As an alleged result of its relaxed underwriting practices, Impac’s portfolio of Alt-A loans carried the same high risk as its portfolio of subprime loans. The plaintiffs further asserted that the defendants misrepresented the overall value of the company by failing to write down the value of its Alt-A loan portfolio.
In dismissing the third amended complaint, the court rejected the plaintiffs’ attempt to apply the “core operations inference,” which allows the court to infer scienter where the alleged practices of the company are so central to the operations of the company that it would be impossible for the officers and directors to be unaware of the misrepresentations regarding those practices. The court emphasized that the “core operations inference” is only available in “exceedingly rare cases,” and concluded that the allegations did not warrant application of the inference. (“Impac Mortgage Subprime Mortgage Securities Lawsuit Dismissed With Prejudice,” D&O Diary, March 12, 2009)
Downey Financial Subprime Securities Action Dismissed
A California federal court judge on March 18, 2009 granted without prejudice the defendants’ motion to dismiss a purported securities class action filed against certain former directors and officers of Downey Financial Corp. The plaintiff filed the action shortly after Downey announced that it had experienced an increase in nonperforming assets. According to the complaint, Downey failed to disclose that its portfolio of option adjustable-rate mortgages (option ARMs) contained millions of dollars worth of impaired and risky securities that were primarily backed by subprime mortgages. Further, Downey allegedly failed to properly account for highly leveraged loans, had not adequately reserved for option ARMs, and the defendant directors and officers made misrepresentations about the company’s financial condition. In November 2008, the Federal Deposit Insurance Corporation took over Downey and sold its assets to U.S. Bank. (“Dismissal Motion Granted in Downey Financial Subprime Securities Suit,” D&O Diary, March 23, 2009)
AIG Unit Seeks to Cancel Insurance Policies Issued on Countrywide Loans
On March 19, 2009, United Guaranty Mortgage Indemnity Co., a unit of American International Group (AIG), filed an action against Countrywide in a California federal court alleging that Countrywide misrepresented the health of loans insured by United Guaranty, which resulted in massive losses. The lawsuit follows AIG’s recently reported $61.7 billion loss for the fourth-quarter of 2008, which largely resulted from subprime loan defaults and represents the biggest quarterly loss in U.S. corporate history. United Guaranty asserts that Countrywide “abandoned its own underwriting guidelines to boost its market share and then misrepresented the quality of its loans so that United Guaranty could provide insurance for them.” In addition to punitive damages, United Guaranty requests that the insurance policies on the loans and the payments on the policies be cancelled. (“AIG Unit Sues Countrywide Over Loan Losses,” Associated Press, March 20, 2009)
NJ Sues Former Lehman Directors and Officers Over Losses on Investments in Lehman Stock
New Jersey filed a lawsuit on March 17, 2009 against former directors and officers of Lehman Brothers alleging that their fraud and misrepresentations caused the state’s public pension fund to lose about $118 million. Direct actions against Lehman have been stayed by bankruptcy proceedings. The lawsuit follows similar actions by other governmental entities against former Lehman executives. In November 2008, San Mateo County, Calif., filed a lawsuit against former Lehman executives seeking to recover a $150 million loss to the county’s investment pool.
The New Jersey lawsuit alleges that the Lehman executives made false and misleading statements about the company’s liquidity, the value of its assets and its ability to hedge against risk. In addition, it is alleged that Lehman executives did not disclose the company’s exposure to losses stemming from the failing real estate market. According to the complaint, the defendants’ “thirst for profit” and “simple greed” caused Lehman to misstate its financial position. In addition to the lawsuit, state Sen. Joseph Pennacchio is calling for legislative hearings into the State Investment Council’s investment practices. The council allegedly included three former Lehman officers and the wife of a former Lehman executive. (“New Jersey Sues Over Lehman Losses,” The New York Times, March 18, 2009)
Ponzi Schemes
SEC Action Against Stanford International and Stanford Financial for Operating Ponzi Scheme
The Securities and Exchange Commission (SEC) on February 17, 2009 filed a complaint in a Texas federal court alleging that R. Allen Stanford and the chief financial officer of Stanford International Bank (Stanford International), James M. Davis, operated an $8 billion Ponzi scheme. Stanford and Davis allegedly falsified records and misappropriated investor funds. Laura Pendergest-Holt, the chief investment officer of Stanford Financial Group (Stanford Financial), was arrested based on charges of obstructing the SEC’s investigation.
In an amended complaint, the SEC asserts that Stanford recruited investors by promising high returns from investments in liquid financial instruments, but instead invested the funds in speculative real estate transactions and private businesses. As further evidence of Stanford Financial’s fraudulent misappropriation of investor funds, the amended complaint alleges that Stanford received a $1.6 billion personal loan from Stanford Financial. The SEC alleges that by the end of 2008, Stanford International held mostly “overvalued real estate” and private equity, in contrast to its representations to investors that it held a “well-diversified portfolio of highly marketable securities.” According to the complaint, Stanford and Davis concealed the fraud by directing Stanford International’s internal accountants to generate false financial statements that reported fictitious income. Stanford International’s reported monthly income was apparently predetermined by Stanford and Davis. (“New SEC Complaint Says Stanford Ran Ponzi Scheme,” The Wall Street Journal, March 1, 2009)
Safra Banking Group to Partially Cover Client Losses From Madoff Ponzi Scheme
Safra Banking Group offered to partially cover losses suffered by its private banking clients from the Bernard Madoff Ponzi scheme. Safra offered investors perpetual bonds in an amount equal to their original investment and paying 2 percent interest a year, which is similar to Banco Santander’s January 2009 offer to compensate its investors who lost money in the Madoff scheme. Although it did not invest its own money directly with Madoff, Safra apparently invested in vehicles linked to Madoff at the request of its private banking clients. It is estimated that Safra could spend up to $40 million on restitution to its clients. Brazilian authorities are apparently investigating the marketing of Madoff-related funds in Brazil, although it is unclear whether Safra is a target of that investigation. (“Bank to Cover Some Madoff Losses,” The Wall Street Journal, March 10, 2009)
SEC Says It Has Uncovered New Ponzi Schemes in Virginia and California
The SEC uncovered alleged Ponzi schemes run through California-based investment firm Equity Investment Management and Trading, Inc. and investment firms Tower Analysis, Inc., Nasco Tang Corp. and Nadia Capital Corp. run by John Donnelly in Virginia. According to the SEC, the investment firms ran Ponzi schemes totaling $51 million. The SEC continues to scrutinize investment firms after being criticized for failing to uncover the Madoff Ponzi scheme. (“SEC Accuses California, Virginia Firms of Running Ponzi Schemes,” Bloomberg, March 11, 2009)
Madoff Pleads Guilty to Operating Multibillion-Dollar Ponzi Scheme
On March 12, 2009, Bernard Madoff pleaded guilty to 11 felony counts related to his operation of a $50 billion Ponzi scheme that defrauded investors worldwide. U.S. District Court Judge Denny Chin revoked Madoff’s bail and ordered him to a jail in lower Manhattan pending his sentencing hearing on June 16, 2009. Madoff faces up to 150 years in prison, but will likely receive a sentence of 20 years. After Madoff pleaded guilty, Judge Chin asked him to describe his crimes to the court. Several of Madoff’s statements conflicted with accusations by prosecutors. For example, Madoff asserted that the fraud began in the 1990s, but prosecutors believe that the fraud began no later than the 1980s. Additionally, Madoff maintained that his fraudulent investment-advisory business, which was responsible for operating the Ponzi scheme, was separate from the brokerage and trading business that he operated and where his two sons worked. A court-appointed trustee, however, has reported that the two businesses are “one.” Madoff did not address the issue of whether anyone else knowingly participated in the fraud. (“Madoff Jailed After Admitting Epic Scam,” The Wall Street Journal, March 13, 2009)
Millennium Bank Accused of Operating Ponzi Scheme
The SEC accused Millennium Bank, its Swiss parent, United Trust of Switzerland SA, and related individuals of running a $68 million Ponzi scheme that misled investors about high returns on certificates of deposit. Millennium, which is licensed in St. Vincent and the Grenadines, allegedly solicited new investors through “blatant misrepresentations and glaring omissions” in online solicitations and advertisements targeting wealthy investors. (“SEC Accuses Caribbean Bank of $68 Million Ponzi Scheme,” Reuters, March 26, 2009)
MF Global, Bank of America Named in Lawsuit Regarding $380 Million Cosmo Ponzi Scheme
MF Global, Bank of America and a number of futures and commodities trading firms have been named as defendants in a lawsuit filed in federal court in Brooklyn arising from a $380 million Ponzi scheme orchestrated by Nicholas Cosmo. In January 2009, the Commodities Futures Trading Commission filed suit against Cosmo and his firm, Agape, alleging that from 2004 to 2008, Cosmo operated a trading scheme in which he asked investors to provide short-term bridge loans but instead put their money into commodities trading contracts that lost money. According to the lawsuit, Bank of America knowingly assisted, facilitated and furthered Cosmo’s fraud by establishing and staffing a branch office at Agape’s headquarters. Although the plaintiff also accuses MF Global of participating in the fraud, an MF Global spokeswoman said that when the firm became aware of Cosmo’s criminal background in October 2008, it closed his individual account and notified regulators. (“Bank of America Accused in Ponzi Scheme,” The New York Times, March 28, 2009)
Bank of Bermuda, Other Offshore Entities and Individuals Named in Madoff Class Action
A securities class action filed in New York federal court on behalf of investors in four hedge funds names as defendants Bank of Bermuda and several other offshore companies and individuals. The investors allegedly lost more than $3 billion in the Madoff scheme. Bank of Bermuda’s subsidiaries apparently served as the administrator, registrar and custodian of the hedge funds. Investment adviser BA Worldwide Fund Management Ltd, Ernst and Young and PricewaterhouseCoopers were also named in the lawsuit.
The plaintiffs contend that the defendants failed to advise investors that the hedge funds were being used as feeder funds for the Madoff Ponzi scheme and that they ignored numerous red flags that required them to conduct further due diligence that they failed to do. (“Lawsuit Filed Against Bank Over Madoff Loss,” The Royal Gazette, March 30, 2009)
Auction Rate Securities
Credit Suisse Settles Auction Rate Securities Claim for $400 Million Plus Fees
On February 13, 2009, the Financial Industry Regulatory Authority (FINRA) announced that Credit Suisse Group agreed to pay STMicroelectronics NV more than $400 million in damages and $6.5 million in fees to resolve claims that it misled the semiconductor maker into buying auction rate securities (ARS). Institutional investors alleged that Credit Suisse misled them about the risks associated with ARS. STMicroelectronics apparently instructed brokers at Credit Suisse to invest in student loan securities backed by U.S. government guarantees. Instead, brokers at Credit Suisse invested STMicroelectronics’ money in unauthorized securities, including risky collateralized debt obligations often backed by subprime loans. STMicroelectronics asserted that Credit Suisse knew its brokers were investing client funds in ARS in an effort to remove the securities from its own inventory and earn higher fees. In 2008, state regulators and the SEC forced various financial institutions to buy back more than $50 billion in ARS to settle claims that the firms falsely promoted the securities as safe, cash-like investments. (“Credit Suisse Ordered to Pay $400 Million in ARS Flap,” The Wall Street Journal, February 13, 2009; “The $400 Million Credit Suisse Auction Rate Securities FINRA Award: Why It Matters,” D&O Diary, February 16, 2009)
ARS Securities Class Action Filed Against Perrigo Company
On March 11, 2009, a purported securities class action was filed against Perrigo Company in a New York federal court on behalf of investors who purchased common stock of Perrigo. The complaint alleges that the company issued false statements regarding its exposure to ARS. According to the complaint, at the beginning of the class period, Perrigo reported the fair market value of its ARS holdings as $14.5 million. The plaintiffs allege, however, that Perrigo’s ARS portfolio had suffered a sharp decline in value due to the bankruptcy of Lehman, which had underwritten and sold about $18 million worth of ARS to Perrrigo. In February 2009, Perrigo announced that it was “writing off the entire value of its ARS,” which caused a one-third decrease to the company’s earnings during the quarter. As an alleged result of the announcements regarding its ARS, Perrigo’s stock price decreased 18 percent. (“Izard Nobel LLP Announces Class Action Lawsuit Against Perrigo Company,” MarketWatch, March 11, 2009; “Securities Lawsuit Targets Auction Rate Securities Investor,” D&O Diary, March 12, 2009)
ARS Securities Class Action Against UBS Dismissed
U.S. District Court Judge Lawrence McKenna dismissed on March 30, 2009 a closely watched lawsuit brought against UBS on behalf of individual investors who said it had misled them when it sold them ARS. Judge McKenna held that the investors were not entitled to continue their litigation because UBS had reached a settlement in the matter in August with the SEC and certain state regulators in which it agreed to buy back nearly $19 million in ARS and pay a fine. In view of this decision, similar ARS lawsuits might also be dismissed. (“Investors Suit Against UBS Is Dismissed,” The New York Times, March 31, 2009)
Government and Regulatory Intervention
Geithner Outlines Proposed New Regulation Scheme for Financial Institutions
On March 26, 2009, Treasury Secretary Timothy F. Geithner outlined the Obama Administration’s broad revamping of the regulatory system for financial institutions. The new rules are intended to prevent a repeat of the excesses that have wreaked havoc on the global financial system. Among other things, the plan would give the federal government vast new powers over “systemically important” financial institutions, or entities that are so big that their collapse would jeopardize the overall economy. In addition, the government intends to regulate hedge funds, private equity funds and venture capital funds as well as the market in derivatives such as credit default swaps. The proposed regulations would require hedge funds, private equity funds and venture capital funds to register with the SEC and provide the government with information on how much they borrow to leverage their investments and about their investors and trading partners. Such information would be shared with a new “systemic risk regulator.” (“Geithner to Outline Major Overhaul of Financial Rules,” The New York Times, March 26, 2009)
Treasury Department Announces Public-Private Investment Program to Clean Up Toxic Assets
The U.S. Treasury Department announced on March 23, 2009 details of its plan to remove toxic assets from the balance sheets of the country’s financial institutions. The plan seeks to allow banks to begin lending again and to address the shortage of capital at major institutions. The Treasury will partner with private investors to buy up assets that are currently at high risk of default, such as assets backed by subprime mortgages and other risky loans. In an effort to create an effective market for the assets, the government will conduct auctions between banks and investors. The government believes that auctions are the most effective means to solve the difficult problem of pricing the assets.
The goal of the plan is to buy and remove at least $500 billion worth of toxic assets from banks’ balance sheets. To encourage private investment in the troubled assets, the government will offer subsidized, low-interest loans. In conversations with Treasury Department officials before the announcement, executives at private equity firms and hedge funds reportedly indicated that they would be reluctant to participate in the public-private investment partnerships unless the government guaranteed that it would not set compensation limits on the firms. Initially, the Treasury Department has committed $75 billion to $100 billion to the program, and will assess the effectiveness of the program before committing additional taxpayer funds. (“Treasury Unveils Long-Awaited ‘Bad-Asset’ Plan,” CNNMoney.com, March 23, 2009; “U.S. Rounding Up Investors to Buy Bad Assets,” The New York Times, March 23, 2009)
AIG Executives Return $50 Million in Bonus Payments
AIG, which was bailed out by the federal government, has been subject to much scrutiny after the public learned that it had paid $165 million in bonuses after receipt of taxpayer money. There have been reports of threats against some AIG employees, and several senior executives working within AIG’s financial products unit have resigned amid the controversy over the executive bonuses.
On March 23, 2009, New York Attorney General (NYAG) Andrew Cuomo reported that 15 of the top 20 executives at AIG have returned their bonus payments, totaling $50 million, as a result of his office’s ongoing investigation into AIG’s distribution of bonuses. Cuomo stated that he “is trying to get the money back because [he] believe[s] it is what the American people deserve.” The NYAG reportedly has been collaborating with AIG in contacting executives to recoup the bonuses. Although Cuomo is hopeful that approximately $80 million of the $165 million in bonus payments will be recouped, the remaining bonus cash was distributed to non-Americans and is likely unrecoverable. (“15 of 20 Top AIG Bonus Recipients Return Cash,” CNNMoney.com, March 23, 2009; “AIG Execs Resign From Controversial Unit,” CNNMoney.com, March 23, 2009)
Fannie Mae Draws Additional $15 Billion From Government Line of Credit
On February 26, 2009, Fannie Mae announced its financial results for the fourth quarter of 2008 and said that it would access $15.2 billion from its line of credit with the federal government. The Obama Administration recently doubled the line of credit available to Fannie Mae and Freddie Mac from $100 billion to $200 billion in an effort to strengthen the two companies, which play a critical role in the Administration’s foreclosure prevention plan. Under that plan, Fannie Mae and Freddie Mac will allow borrowers to refinance their mortgages and will subsidize interest rates to lower monthly payments for borrowers who are in or near default. Fannie Mae and Freddie Mac were both placed into conservatorship by the federal government in September 2008.
Despite the government’s efforts to reorganize and fortify Fannie Mae, the company lost $25.2 billion during the fourth quarter of 2008 and a total of $58.7 billion during 2008. In addition to its fourth quarter losses, Fannie Mae announced a dismal forecast for the U.S. housing market during 2009, stating that it expects home values to decline between 12 percent and 18 percent and peak-to-trough price declines to be in the 33 percent to 46 percent range. (“Fannie Taps Lifeline After $59B in Losses,” CNNMoney.com, February 26, 2009)
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