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Publications
Credit Crunch Digest
April 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 status of the Madoff, Rothstein, Petters, Nadel and Aliaga Ponzi schemes and related litigation, and the status of financial regulatory reform legislation in response to the subprime crisis and credit crunch.
Litigation and Regulatory Investigations
Fraud and Ponzi Schemes
Auction Rate Securities
Government and Regulatory Intervention
Litigation and Regulatory Investigations
Banks Fare Well in Credit Crisis-Related Lawsuits
According to recent studies by analysts, it appears that banks have had success in fighting lawsuits filed by investors stemming from the financial crisis. It appears that the majority of these lawsuits accuse financial firms of misrepresenting the risks of various products, including mortgage-backed securities (MBS). According to a former Securities and Exchange Commission (SEC) commissioner and professor at Stanford Law School, “judges across the country are realizing that not every massive loss of investor capital is caused by fraud.” In addition, analysts note that it appears investors are beginning to recognize that a possible reason for the collapse of the financial market is mistake, rather than fraud. Since the end of 2007, approximately 40 securities fraud cases have been dismissed in the early stages, compared with approximately 20 cases in which some claims were allowed to proceed with discovery. Analysts have determined that the usual dismissal rates for securities fraud cases are between 33 percent-40 percent. In cases where the plaintiffs survived the motion to dismiss stage, they were able to point to specific questionable acts within a company, such as alleged insider trading. (“Banks Winning When Investors Sue,” The Wall Street Journal, April 8, 2010)
Shareholders File Claims Against MBIA
Bond insurer MBIA Inc. faces a continuing legal battle regarding shareholder claims stemming from the collapse of the mortgage-backed securities (MBS) market. In a mixed ruling, U.S. District Judge Kenneth Karas of the Southern District of New York dismissed investor claims against MBIA’s former Chair and Chief Executive Officer Gary Dunton and current Chief Financial Officer Edward Chaplin. Judge Karas, however, ordered the lead plaintiff, the Teachers Retirement System of Oklahoma, to amend its complaint within 30 days regarding the remaining claims against the insurer. According to the lawsuit, MBIA is alleged to have misrepresented its risk exposure to certain collateralized debt obligations (CDOs) containing residential MBS. The case is In Re MBIA Inc Securities Litigation, U.S. District Court for the Southern District of New York, No. 08-264. (“U.S. Judge OKs Some Claims vs MBIA, Dismisses Others,” Reuters.com, March 31, 2010)
Rating Agencies Win Dismissal of Mortgage Bond Suit
On April 1, 2010, Standard & Poor’s and Moody’s Corp. both won dismissals of a lawsuit alleging the rating agencies defrauded investors who relied on their ratings before buying $63 billion of investment-grade MBS. The plaintiffs alleged that banks and rating agencies made untrue statements and omissions in registration statements and prospectuses regarding the safety of MBS sold in 84 offerings. In a brief two-page order, U.S. District Judge Jed Rakoff dismissed the plaintiffs’ claims against the rating agencies and advised that he intends to issue a detailed opinion discussing the reasons for dismissal. According to defense counsel for a co-defendant in the lawsuit, “the likely reason to come from Judge Rakoff’s opinion will be important to many defendants in financial crisis litigation.” (“Standard & Poor’s, Moody’s Win Dismissal of Mortgage Bond Suit,” BusinessWeek.com, April 1, 2010)
Court Rules on Residential Capital’s Motion to Dismiss in Mortgage-Backed Certificates Lawsuit
On March 30, 2010, Judge Harold Baer Jr. of the U.S. District Court for the Southern District of New York granted in part and denied in part the defendants’ motions to dismiss the complaint filed against Residential Capital LLC regarding the issuance of certain mortgage-backed certificates. Judge Baer granted the motions to dismiss with respect to: (i) the plaintiffs’ standing to bring claims for 55 of the 59 offerings at issue; (ii) the plaintiffs’ allegations regarding the defendants’ credit rating model; and (iii) the plaintiffs’ allegations regarding the defendants’ failure to disclose conflicts of interest with the credit rating agencies. The court found that the plaintiffs did not have standing to bring securities claims for the offerings in which no plaintiff purchased shares. The court also found that the plaintiffs failed to allege that the offerings “did not receive the stated credit rating or credit enhancements detailed in the offering documents.” The court ruled that the defendants had no duty to disclose any conflict of interest with the credit rating agencies. Judge Baer denied the defendants’ motions to dismiss, however, with respect to the allegations that the originator of the mortgages backing the certificates “systematically disregarded” the underwriting guidelines as represented in the offering documents. (“Surge in Rulings in Subprime-Related Securities Case Continues,” The D&O Diary, April 7, 2010; New Jersey Carpenters Health Fund, et al. v. Residential Capital, LLC, et al., No. 08-CV-8781 (HB) (S.D.N.Y. March 31, 2010)
Subprime Lawsuit Against Canadian Imperial Bank Dismissed
On March 17, 2010, Judge William H. Pauley III of the U.S. District Court for the Southern District of New York granted the defendants’ motion to dismiss a purported securities class action lawsuit filed against Canadian Imperial Bank of Commerce (CIBC) and four CIBC executives. The lawsuit alleged that the defendants made false and misleading statements to investors in press releases and other public statements regarding CIBC’s exposure to subprime MBS. Judge Pauley found that the plaintiffs failed to adequately allege that CIBC and its executives were aware of information contrary to the representations made in their public statements. According to Judge Pauley’s decision, CIBC’s “incremental measured response” to the “meltdown in the mortgage market” is “as plausible an explanation for the losses as an inference of fraud.” Judge Pauley noted that CIBC did write down its portfolio of MBS six times during the class period of May 31, 2007 to May 29, 2008. (“CIBC Suit Is Dismissed,” The Wall Street Journal, March 18, 2010)
Fraud and Ponzi Schemes
Petters Sentenced to 50 Years
On April 8, 2010, Judge Richard Kyle sentenced Tom Petters to 50 years in prison for orchestrating a $3.65 billion Ponzi scheme in which he convinced investors to give his company, Petters Company, Inc., money to purchase electronics to be sold to large retailers, including Costco and Sam’s Club. The sentence represents the longest prison term ever ordered in Minnesota in connection with a financial fraud case. In December 2009, the 52-year-old was found guilty on 20 counts, including wire fraud, mail fraud, money laundering and conspiracy to commit further fraud, for diverting funds from investors to pay prior investors and to finance his extravagant lifestyle. Several of his co-conspirators have pleaded guilty but have not yet been sentenced. During sentencing, Judge Kyle noted that if Petters received a more lenient sentence, he doubted Petters would refrain from committing further crimes. (“Tom Petters Gets 50 Years for Ponzi Scheme,” CNNMoney.com, April 8, 2010)
Rothstein’s Financial Adviser Earned $33 Million for Participating in the Ponzi Scheme
On April 6, 2010, the bankruptcy trustee overseeing the bankruptcy of Scott Rothstein’s former law firm, Rothstein, Rosenfeldt & Adler, P.A., filed a motion seeking an emergency court order freezing the assets of Rothstein’s former financial advisor, Michael Szafranski. The motion alleged that Szafranski, along with his companies, received approximately $33 million for falsely verifying fabricated structured settlement agreements, which formed the basis of Rothstein’s alleged $1.4 billion Ponzi scheme. The bankruptcy trustee’s motion alleged that Szafranski’s involvement in the alleged Ponzi scheme is “undeniable.” The motion papers further allege that, during a deposition on March 8, 2010, Szafranski purportedly refused to answer questions about his interaction with investors in the scheme and his knowledge of the structured settlement agreements. Lawyers for Szafranski alleged that he invoked his right to remain silent due to an ongoing federal investigation into Rothstein’s fraudulent scheme. (“Rothstein Bankruptcy Attorneys Seeking to Freeze $33 Million Paid to Financial Advisor,” SunSentinel.com, April 7, 2010)
Connecticut Attorney General Investigating Bank’s Ties to Madoff
The Connecticut Attorney General’s office and the Connecticut Department of Banking are investigating whether Westport National Bank and PSCC Services Inc. (PSCC), a pension consultant, aided and abetted Bernard Madoff in his fraudulent Ponzi scheme. According to an announcement by the Connecticut attorney general on April 6, 2010, the investigation is based on allegations that Westport National Bank and PSCC received $2.5 million and $14 million in fees, respectively, for soliciting investors and operating funds that invested in Madoff’s Ponzi scheme. Clients of Westport National Bank allegedly invested approximately $59 million with Madoff. Those clients received statements from the bank that represented that they had invested in “shares” with specific market values. (“Update 1 – Connecticut Probing Bank Linked to Madoff,” Reuters.com, April 6, 2010)
Federal Regulators Uncover Alleged Ponzi Scheme in Florida
On April 6, 2010, the U.S. Commodity Futures Trading Commission (CFTC) filed a lawsuit in federal court in Miami against CMA Capital Management LLC and its owner, Claudio Aliaga, as well as Global Investment Fund LLC and its owner, Betty Aliaga. According to the lawsuit, the defendants were operating a $4.5 million Ponzi scheme. Claudio Aliaga apparently solicited investors for Global Investment Fund by promising returns of 2 percent to 3 percent per month on foreign exchange investments, and he allegedly represented to investors that they were, in fact, earning such returns on their investments. However, according to the CFTC, Claudio Aliaga traded only half of the funds that he received from investors and used the remainder of the funds for personal expenses and to pay off previous investors. In the lawsuit, the CFTC seeks monetary penalties, cancellation of all existing contracts and disgorgement of customer funds. Additionally, the lawsuit seeks to prevent the Aliagas from engaging in future commodity trading activities. (“Feds: CMA Capital Management a Ponzi Scheme,” South Florida Business Journal, April 7, 2010)
Judge Permits Lawsuit Against Holland & Knight to Recover Funds Lost in Nadel’s Ponzi Scheme
In a recent decision by Judge Rick DeFuria of the Circuit Court of Sarasota, Florida, Judge DeFuria allowed claims for malpractice and breach of fiduciary duty against Holland & Knight and one its partners, Scott MacLeod, to proceed in a lawsuit brought by the law firm Wiand Guerra King, the receiver appointed to recover funds lost in a $168 million Ponzi scheme orchestrated by former hedge fund manager Arthur Nadel. Wiand alleged that Holland & Knight prepared disclosure documents for investors that purportedly failed to mention that Nadel, a former New York attorney, had been disbarred for stealing funds from his clients’ escrow accounts. The lawsuit also alleges that the law firm violated ethics rules regarding conflicts of interest by representing both Nadel and his investment funds simultaneously. Wiand seeks $168 million from Holland & Knight. (“Judge Lets Stand Nadel Receiver’s Lawsuit Against Holland & Knight,” Law.com, March 17, 2010)
Auction Rate Securities
Merrill Lynch Ordered to Pay New Jersey $4.87 Million
On April 6, 2010, New Jersey Attorney General Paula Dow announced that Merrill Lynch has agreed to pay $4.87 million in penalties to end an investigation into the financial firm’s marketing of auction rate securities. Merrill Lynch has also agreed to repurchase auction rate securities from private investors. According to state officials, the securities were marketed as a safe and accessible alternative to cash. However, when the $330 billion market for the securities crashed in 2008, many investors were left with illiquid auction rate securities. The settlement with New Jersey is part of a multistate agreement that Merrill Lynch has entered regarding the marketing of auction rate securities. The potential amount of repurchases from private investors has not been disclosed. (“Merrill Lynch to Pay N.J. $4.9M In Penalties,” NJ.com, April 7, 2010)
Government and Regulatory Intervention
SEC Expects to Bring More Credit Crisis-Related Lawsuits
In an interview on March 29, 2010, Mary Schapiro, chair of the SEC, said that the SEC has spent a great deal of time in the past year to refocus the agency and bring in the right people in order to restore investor confidence and the integrity of the marketplace. Schapiro noted that the SEC has already brought approximately a dozen cases related to the financial crisis, including State Street and Evergreen, and cases against executives at Countrywide Financial and Beazer Homes. According to Schapiro, “there are many more [cases] in the pipeline.” Specifically, Schapiro noted that the SEC is closely watching the Lehman Brothers Bankruptcy case and will be probing the accounting procedure known as “Repo 105” with “every major financial institution very thoroughly” in the coming months. (“More Crisis-Related Cases in the Pipeline: SEC’s Schapiro,” CNBC.com, March 29, 2010)
Fed Inquiry Into Financial Crisis Reveals Errors in Oversight of Citigroup
In July 2009, six Democrats and four Republicans were appointed to the Financial Crisis Inquiry Commission to examine the causes of the financial crisis and how the issuance of risky subprime mortgage debt contributed to the country’s financial meltdown. To date, the commission has held hearings with chief executives of several Wall Street banks and former Federal Reserve (Fed) Chair Alan Greenspan. The commission will also hear testimony from top executives of Fannie Mae regarding its role in the mortgage crisis. During Greenspan’s testimony before the commission, panelist Brookley E. Born stated that the Fed “utterly failed to prevent the financial crisis” and “failed to prevent the housing bubble.” When asked whether the Fed failed to meet its responsibilities, Greenspan acknowledged that the Fed’s failure arose from its “underestimation of the ‘state and extent’ of financial risks” and the ability to assess those risks.
With respect to Citigroup, on April 7, 2010, the Fed turned over to the commission two reviews indicating a lack of proper staffing and inadequate oversight both before and after Citigroup’s financial troubles were revealed to the public. During hearings on April 8, 2010, the commission criticized former leaders of Citigroup for their role in the financial crisis, including Charles “Chuck” Prince, former chief executive of Citigroup, and Robert Rubin, who was a board member and a top adviser at Citigroup. In testimony before the commission, Prince purportedly apologized for his role in the crisis, stating that he is sorry Citigroup’s management “was not more prescient.” Prince retired in 2007 after the company announced it would write down approximately $11 billion in losses resulting from its holdings of mortgage-backed securities, which ultimately led to the company accepting a $45 billion government bailout.
Analysts speculate that any report generated by the commission could have a modest impact in light of the House’s recent approval of a sweeping financial reform bill. The Senate is scheduled to vote on the bill this summer. (“Financial Crisis Inquiry Wrestles With Setbacks,” The New York Times, April 5, 2010; “Former Citibank Leaders Grilled by Crisis Panel,” CnnMoney.com, April 8, 2010)
SEC Proposes Stricter Regulation of Bonds Backed by Consumer Loans
On April 7, 2010, the Securities and Exchange Commission (SEC) proposed a new rule to regulate certain bonds backed by bundles of consumer loans, including residential mortgages, student loans and automobile loans. Under the proposed regulation, bond underwriters would no longer be required to obtain a credit rating, but the chief executive of a bond issuer would be required to certify that the assets backing a particular bond are likely to produce projected cash flows. Additionally, bond issuers would be required to retain as much as 5 percent of the securities from each offering. Regulators from the SEC explained that prior to the financial crisis under the current regulatory framework, bond issuers had “little incentive to ensure that bonds were backed by reliable loans.” The proposed regulation also mandates bond issuers to provide the SEC with “extensive information, in a form that is easily searchable” for each individual loan in the portfolio backing a particular bond and to update that information on a continuing basis. Currently, issuers are required only to provide information regarding the overall credit quality of the entire pool of loans backing a bond. The disclosure requirements would apply to private placements of bonds as well as to securities sold in public offerings. Opponents of the new regulation have commented that the proposed rule could “alter the economics of private-placement transactions to the point of destroying the market.” (“SEC Moves to Tighten Rules on Bonds Backed by Consumer Loans,” The New York Times, April 7, 2010)
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