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Publications
Credit Crunch Digest
May 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, 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.
Litigation and Regulatory Investigations
Ponzi Schemes
Auction Rate Securities
Government and Regulatory Intervention
Litigation and Regulatory Investigations
First Quarter 2009 Securities Class Action Filings Predict Increase Over Last Year Totals
In the first quarter of 2009, 169 securities lawsuits were filed – up from 134 filings during the first quarter of 2008. Commentators predict securities actions are on pace to surpass 2008 totals by 38 percent. One hundred and eight of the 169 lawsuits filed were against financial firms, and were driven primarily by the Madoff Ponzi scheme fallout. Madoff-related cases accounted for 30 percent of all securities cases in the first quarter and the subprime/credit crisis made up 26 percent of securities actions. Observers note that errors and omissions (E&O) insurers may see increasing claims for Madoff and subprime-related cases, which deal with professional judgment and fiduciary duties, may be excluded under directors and officers’ (D&O) policies and covered under E&O policies. Most of the cases filed this quarter have been brought in federal courts sitting in New York, California, Texas and New Jersey. The first-quarter figures also include 27 cases filed outside the United States. Although securities action filings in 2009 presently appear to be on track to exceed the filings in 2008, commentators note that the onslaught of Madoff-related actions in the first quarter of 2009 may have skewed the outlook and filings in 2009 may taper off in subsequent quarters. Further, it is expected that the wave of subprime-related actions may level off in 2009.
During the first quarter, 76 cases were either settled or received damage awards with an average settlement or award amount of $27.9 million with securities fraud cases having the highest average of $43.4 million. For the most part, the average results are in line with 2008, which had an average settlement/award amount of $25.5 million. (“Securities Litigation Surges in 2009: An Advisen Quarterly Report - Q1 2009,” Advisen, May 4, 2009)
Beazer Resolves Subprime-Related Securities Action For $30.5 Million
On May 5, 2009, homebuilder Beazer Homes announced its settlement of a subprime-related securities class action for payment of $30.5 million, which reportedly will be funded entirely by the company’s insurers. Beazer is a residential home builder that provided mortgage finance services to home buyers. In addition to ongoing investigations by the SEC and other regulatory authorities into its mortgage lending practices, Beazer’s audit committee allegedly concluded that the company’s loan origination practices failed to meet certain state and federal requirements and discovered accounting errors that required restatement of its financial statements for the previous nine years. The settlement, which apparently was reached before the motion to dismiss was decided, remains subject to court approval. (“Beazer Homes Settles Subprime Securities Lawsuit,” D&O Diary, May 5, 2009)
Court Dismisses Subprime Securities Action Against Radian
On April 9, 2009, a federal judge in the Eastern District of Pennsylvania dismissed a securities action pending against Radian Group without leave to amend. The plaintiffs alleged that Radian and several of its directors and officers made false and misleading statements about the profitability and liquidity position of Credit Based Servicing & Asset Securitization (C-Bass), an affiliate company in which Radian was a minority owner. Radian allegedly misled investors about the financial health of C-Bass, which invested in the credit risk of subprime residential mortgages. Ultimately, Radian shareholders suffered losses when Radian announced an impairment of its investment in June 2007. In granting the motion to dismiss, the court found that the plaintiffs failed to adequately plead scienter. Specifically, the court found that the allegations “did not establish with sufficient particularity that the defendants knew or should have known that their statements presented an obvious danger of misleading the investing public.” In addition, the court found that deteriorating conditions in the subprime marketplace were known to the plaintiffs and the market at large, and that Radian publicly disclosed its knowledge of these facts and their potential effect on its investment in C-Bass. (“Radian Group Subprime Securities Suit Dismissed,” D&O Diary, April 10, 2009)
Bailout Money May Fund Securities Lawsuit Settlements
Since January 2009, 19 of the 32 recipients of funds from the federal Troubled Asset Relief Program (TARP) have been sued in securities class action lawsuits. Commentators have noted that $240 billion of the $300 billion in TARP funds paid to financial institutions is subject to shareholder litigation, and expressed concern that TARP funds could be used to settle these lawsuits. For example, on January 16, 2009, the federal government announced that it would invest $20 million from TARP in Bank of America and guarantee $118 billion of assets to assist in its acquisition of Merrill Lynch. On that same day, Merrill Lynch announced its agreement to pay $500 million to settle a securities class action against the company and several of its directors and officers alleging that the defendants knew or recklessly disregarded Merrill Lynch’s exposure to collateralized debt obligations containing subprime debt and failed to disclose the company’s exposure to the deteriorating subprime mortgage market. The Merrill Lynch settlement suggests that companies that would have gone bankrupt if not for federal bailout money are having their settlements funded by the federal government and taxpayers. In addition, it has been suggested that companies receiving TARP funds that subsequently settle securities class actions for significant sums may be less likely to pay back the bailout money to the federal government. (“Another View: A Bailout for the Plaintiff’s Bar,” The New York Times Dealbook, April 29, 2009; “Will TARP Money Fund Securities Lawsuit Settlements?”, D&O Diary, May 1, 2009)
Ponzi Schemes
SEC Files Charges Against Toronto-Based Hedge Fund Manager
On April 6, 2009, the Securities and Exchange Commission (SEC) charged Weizhen Tang and the Toronto-based hedge fund that he operates, the Oversea Chinese Fund Limited Partnership (the fund), with operating a Ponzi scheme. The SEC alleges that Tang solicited as much as $75 million for the fund from approximately 200 investors beginning as early as 2004. Tang allegedly solicited members of the Chinese American community, describing himself as the “Chinese Warren Buffett.” According to the SEC, Tang raised capital for the fund by selling limited partnership interests in WinWin Capital Limited Partnership, a Texas partnership controlled by Tang with the sole business purpose of investing capital in the fund. In February 2009, Tang revealed to investors that he reported false profits on their account statements and used funds from new investors to pay out false profits to current investors. During April 2009, Tang informed investors that he is raising $1 million in additional capital to “recoup” investor losses. The SEC has obtained a freeze on the assets of Tang and the Fund. (“SEC Charges ‘Chinese Warren Buffett’ of Ponzi Scheme,” Reuters, April 6, 2009)
CEO of Private Equity Management Group Charged With Fraud
On April 28, 2009, the SEC filed a civil complaint in a California federal court against Danny Pang and obtained a temporary order freezing his assets. According to the SEC, Pang defrauded investors out of hundreds of millions of dollars through two businesses that he operated, Private Equity Management Group, Inc. and Private Equity Management Group LLC. Pang allegedly began raising funds from investors in 2003 by selling securities in his companies, which he represented would generate profit by purchasing life insurance policies at a discount before maturity and collecting on the policies upon the death of the insured. According to the complaint filed by the SEC, however, as Pang was unable to earn enough profit from the life-insurance policies to pay the returns that he had promised his investors, he began to pay existing investors from funds that were invested in his companies for the purpose of investing in timeshares. After a newspaper article revealed the allegedly fraudulent investment practices of Pang and his two companies in early April 2009, Pang temporarily resigned as chairman and CEO of Private Equity Management Group, Inc., and the company formed a special committee and hired outside counsel to investigate the alleged fraud. In addition to issuing a temporary order freezing the assets of Pang and his companies, the judge appointed a receiver to safeguard the assets of the two companies. (“SEC Charges Danny Pang With Fraud; Assets Frozen,” The Wall Street Journal, April 28, 2009)
Stanford Seeks Intervention From U.S. Court of Appeals in Fraud Case; CEO to Negotiate Plea Deal
On April 20, 2009, Allen Stanford asked the Fifth U.S. Circuit Court of Appeals to intervene in a civil fraud case filed against him arising out of his alleged operation of an $8 billion Ponzi scheme. He challenges the lower court’s order freezing $1.7 billion in assets and appointing a receiver to oversee his company’s operations. Stanford denies any allegation that a Ponzi scheme existed and has asked the Fifth Circuit to release $10 million to pay for his defense.
Meanwhile, attorneys for Stanford Group Chief Executive Officer James M. Davis announced that Davis will enter plea negotiations with prosecutors and regulators to resolve potential criminal and civil liability related to the $8 billion Ponzi scheme. The SEC has filed fraud charges against Stanford, Davis and Stanford Group Co.’s Chief Investment Officer Laura Pendergast-Holt, accusing them of running a “massive ongoing fraud” involving the sale of certificates of deposit through Antigua-based Stanford International Bank. Davis first began cooperating with federal investigators in an effort to locate Stanford’s assets, including London bank accounts worth approximately $105 million. In early April 2009, a high court in the U.K. ordered that the bank accounts be frozen. Although Stanford and Davis have not been criminally charged, Pendergast-Holt has been charged with criminal obstruction of the investigation and released on $300,000 bail. (“Stanford Asks Appeals Court to Intervene,” Yahoo!, April 20, 2009; “Stanford’s Davis Will Try to Negotiate Plea Deal, Lawyer Says,” Bloomberg.com, April 10, 2009; “U.S. Appeals Court Denies Stanford Investors’ Request,” Reuters, April 7, 2009)
NYAG Accuses Hedge Fund Manager of Fraud Related to Madoff Investments
On April 6, 2009, the New York attorney general (NYAG) filed a civil complaint against hedge fund manager Ezra Merkin for alleged fraud arising out of his management of funds, which he allegedly “funneled” into Bernard Madoff’s investment firm. The complaint does not allege that Merkin was aware of Madoff’s Ponzi scheme. Instead, the NYAG asserts that Merkin improperly concealed his investment activities from his hedge fund clients. Merkin managed funds for Ascot Partners LP, Gabriel Capital Corp. and Ariel Fund Ltd., which are hedge funds whose investors include universities and non-profit organizations. Merkin allegedly represented to investors in the three hedge funds that he was managing the money himself. According to the complaint, however, Merkin channeled approximately $2.4 billion worth of their investments into Madoff’s firm for more than a decade while earning “hundreds of millions of dollars in fees” for himself. New York University, New York Law School and Mortimer Zuckerman, the owner of the New York Daily News, also filed lawsuits against Merkin for alleged misrepresentations regarding his investment of their funds.
Merkin allegedly misrepresented to investors that 60 percent of Ascot was invested in his personal family trusts. According to the complaint, most of Ascot’s investors were unaware that their money was, in fact, being funneled to Madoff’s investment firm. Merkin’s attorney has disputed that claim and asserted that investors had “expressly authorized” Merkin to invest funds with third-party money managers such as Madoff. Merkin allegedly earned approximately $169 million in fees from his management of Ascot from 1995 to 2007. Merkin also allegedly told investors in Gabriel and Ariel that he was investing their funds in distressed assets and bankruptcies. Contrary to that representation, however, Merkin allegedly invested large portions of those investors’ funds in Madoff’s scheme beginning in 2000. (“Financier Charged in Madoff Fraud,” The Wall Street Journal, April 7, 2009)
Hedge Fund Investors Sue Over Madoff Investments
On April 17, 2009, a purported class action lawsuit was filed in New York federal court against hedge fund Meridian Capital Partners and its investment manager Diversified Fund Management LLC on behalf of investors who purchased shares of the fund between January 2, 2008 and December 11, 2008. Meridian and Diversified allegedly made false statements and breached their fiduciary duties to the plaintiffs by investing 6 percent to 8 percent of Meridian’s funds with Madoff. As an alleged result of the false statements, the plaintiffs made additional investments in Meridian and/or held shares that they otherwise would have sought to redeem.
On April 20, 2009, another purported class action lawsuit arising from a hedge fund’s investments with Madoff was filed in New York federal court. The plaintiffs allege that the defendants, J.P. Jeanneret and Ivy Asset Management, which is a subsidiary of Bank of New York Mellon Corp., “failed to follow a sustainable investment strategy and failed to conduct ongoing due diligence in order to identify and avoid massive fraud.” Specifically, the complaint alleges that J.P. Jeanneret mismanaged the Income-Plus Investment Fund by investing with Madoff. A spokesperson for Ivy Asset Management denied that it is the investment manager for the Income-Plus Fund and stated that neither Ivy Asset Management nor Bank of New York Mellon is affiliated in any way with the Income-Plus Fund. (“Two More Funds, Managers Sued Over Investments With Madoff,” The Wall Street Journal. April 21, 2009)
Investors File Involuntary Bankruptcy Petition Against Madoff
On April 10, 2009, a federal judge reversed his earlier ruling, which prevented investors from filing petitions against Madoff in bankruptcy court. The SEC, the U.S. Attorney’s Office and the Securities Investor Protection Corp. (SIPC) were opposed to allowing investors to file bankruptcy petitions because of a concern that such action would “spawn wasteful litigation.” On April 13, 2009, five Madoff investors filed an involuntary bankruptcy petition in a federal bankruptcy court in New York seeking to force Madoff into Chapter 7 bankruptcy. The five investors allege that together they have approximately $64 million in claims against Madoff. The bankruptcy petition has been assigned to the judge overseeing the liquidation of Madoff’s business. (“Madoff Investors Petition to Force Bankruptcy Filing (Update 3),” Bloomberg.com, April 13, 2009)
Court Approves Sale of Madoff’s Market-Making Business
On April 20, 2009, a federal bankruptcy judge approved the sale of Madoff’s market-making business to Castor Pollux Securities LLC for $25.5 million. Madoff had valued his market-making unit at “hundreds of millions of dollars.” The proceeds from the sale will be used to compensate victims of Madoff’s Ponzi scheme. Castor Pollux, which placed the highest bid at an auction conducted by the court-appointed trustee, will pay $1 million of the purchase price for the business at the closing and the balance of the purchase price in deferred compensation through December 2013. Although a dispute over the ownership of certain patents used for electronic trading by the unit remains unresolved, a license for use of the patents by Castor Pollux is not a requirement for closing the sale. In addition to the sale of the market-making unit, the trustee plans to sell Madoff’s plane and his interest in NetJets, among other assets, in an effort to compensate victims of his Ponzi scheme. (“Judge Backs Sale of Madoff Market-Making Unit,” The Wall Street Journal, April 30, 2009)
Offshore Hedge Funds: Key Issues and Recent Decisions Regarding Investor Redemptions
As an increasing number of investors in troubled hedge funds have sought to redeem, litigation involving hedge fund bylaws over redemption rights has proliferated in recent months. Several issues have emerged in such litigation, including: “[1] disputes over the control of hedge funds as their value spirals downward and competing liquidation strategies emerge; [2] conflicts of interest between earlier redeeming investors and later redeemers and between those two groups together and those ‘left holding the bag’ (very often the founders of the fund) looking to preserve the value at the expense of exiting investors; [3] difficulties in valuing a fund’s net asset value (NAV) in times of extreme volatility and limited liquidity; and [4] the discovery of fraud…”
Several recent decisions in offshore jurisdictions have addressed these issues. For example, in November 2008, the Bermuda Supreme Court analyzed whether a hedge fund may retroactively apply a downwardly adjusted NAV to investors who redeemed prior to discovery of fraud in an underlying fund (e.g., the Madoff Ponzi scheme), and thus received an artificially inflated NAV for their shares at the time of redemption. The argument for adjusting the NAV for such redeemers is that the investors that remained in the hedge fund after discovery of the fraud were forced to “absorb the losses following a substantial NAV write-down” while the investors who redeemed prior to discovery receive the “benefit” of the fraud. In the particular case before it, the Bermuda Supreme Court noted that the fund had a bylaw that stated a NAV given “in good faith … shall be binding on all parties,” and the court found that there was no evidence that the NAV for investors who redeemed prior to discovery of the fraud was given other than in good faith. Therefore, the court held that the fund could not force the early redeemers to account for the “inflated” NAV that they received for their shares.
In another case, the Cayman Islands Court of Appeals found in December 2008 that “redeemers became creditors at the date of redemption, notwithstanding the redemption value had yet to be quantified.” The court held, however, that the redeemers’ shareholder claims, subject to fund bylaws and lacking the right to petition the fund as a creditor, do not accrue until the date of payment of redemption proceeds has passed. (Nick Miles and Mark Chudleigh, “After Madoff, Where Now for Offshore Hedge Funds?”, Insurance Day, May 1, 2009)
Auction Rate Securities
Court Grants Motion to Dismiss in UBS ARS Action
On March 30, 2009, a federal judge granted the motion to dismiss filed by UBS in the action styled In re UBS Auction Rate Securities Litigation and ruled that securities class action plaintiffs who availed themselves of the proceeds from UBS’ ARS regulatory settlement cannot separately maintain claims for damages against the company. On August 8, 2008, UBS announced that it had entered into a nearly $20 billion settlement with state and federal regulators regarding its sale of ARS. UBS agreed to buy back the securities from retail investors at par value or make up the difference to retail investors who already sold them for less than par. Under the regulatory settlement, the lead plaintiffs in the lawsuit received a refund of the purchase price of their ARS and retained the interest and/or dividends they received during the time they held the ARS. Despite this, the plaintiffs argued that they were entitled to damages because “UBS’ fraudulent acts prevented [p]laintiffs from receiving a sufficiently high interest rate or dividends to compensate them for the risk of illiquidity associated with their ARS investments.” In its decision, the court explained that, when the plaintiffs elected to have UBS buy back their ARS at par value, they received a full refund of the purchase price. As a result, the plaintiffs already were in the position they were in before purchasing the ARS and before the fraud ensued. As the plaintiffs availed themselves of the relief provided for in the regulatory settlement, the plaintiffs cannot now allege out-of-pocket damages. (“UBS Dismissal: The End of Auction Rate Securities Lawsuits?” D&O Diary, April 1, 2009)
Wachovia and Citigroup Agree to Buy Back More Than $9 Billion ARS in Multistate Settlements
On April 2, 2009, Washington state regulators announced that Wachovia Bank agreed to buy back more than $8.5 billion ARS as part of a multistate settlement agreement. Wachovia agreed to buy back the ARS by June 30, 2009 and to pay $50 million in penalties, including nearly $500,000 to Washington state. Wachovia allegedly misrepresented to customers that ARS were safe and liquid investments. In addition, the bank allegedly failed to adequately supervise salespeople who marketed and sold these securities to Wachovia customers. The settlement is open to investors who bought Wachovia ARS before February 13, 2008, when the auction market for these types of securities collapsed.
Michigan regulators also announced in April that Citigroup Global Markets Inc. and divisions of Wachovia have agreed to buy back approximately $876 million of ARS held by Michigan investors to resolve a multistate investigation into their ARS sale practices. According to Michigan’s Office of Financial and Insurance Regulation, the settlement requires Citigroup to buy back up to $717 million ARS and Wachovia up to $159 million from Michigan residents. Citigroup and Wachovia are also required to pay the state a total of $2.37 million as administrative compensation for its investigation. Last September, Comerica Inc. agreed to buy back $1.46 billion ARS from Michigan investors as part of the same multistate investigation. (“Wachovia Agrees to Buy Back Securities, Pay Fines,” Seattle Post-Intelligencer, April 2, 2009; “Citigroup, Wachovia in $876M Mich. ARS Buyback,” Financial Planning, April 17, 2009)
Government and Regulatory Intervention
U.S. Treasury Secretary: Bank Stress Test Results Should Reassure Investors
During an interview on May 6, 2009, U.S. Treasury Secretary Timothy Geithner stated that none of the 19 banks subjected to government stress tests are insolvent, a fact that he believes will be “reassuring” to investors when the results are made public. Geithner noted, however, that some of the banks tested will need to raise additional capital. Options available to those banks to raise capital include: raising new common equity from existing or new investors, converting preferred shares held by private investors or the government into common equity, selling additional assets or applying for additional capital from the government. It is expected that those banks will disclose their strategies to raise the needed capital following disclosure of the results, but Geithner expects most banks will raise funds through public sources instead of requesting government assistance. He noted, however, that the government is willing to take larger stakes in the banks if necessary. According to reports, Bank of America may need as much as $34 billion in additional capital. Citigroup, Wells Fargo and GMAC are also among the companies expected to need more capital.
In his opinion, release of the stress test results will help the Treasury’s Public-Private Investment Program, designed to help remove bad assets from bank balance sheets by offering government loans to investors willing to purchase them. Geithner believes banks will have a strong incentive to sell those assets at reasonable prices to raise need capital. He expects the program to be “up and running in the next four to six weeks.”
Geithner expects more than $25 billion of TARP funds will be repaid in the next six to 12 months, which will allow the government to act as a “backstop” for financial institutions if necessary. Several banks, including Goldman Sachs and JPMorgan, have stated they want to repay TARP funds immediately. If the stress test shows the banks have sufficient capital and can borrow money without using a FDIC guarantee, Geithner stated that they will be able to repay the funds.
Geithner also stated that the Obama Administration continues to consider parameters for compensation practices at financial institutions. According to Geithner, bank supervisors and the SEC will set out “broad standards and principles” for compensation to ensure pay incentives “don’t create too much risk of excessive risk-taking in the future.” (“Geithner Says Banks’ Stress-Test Results Will Be ‘Reassuring,’” Bloomberg, May 7, 2009)
FDIC Announces Additional Bank Failures
On April 24, 2009, the Federal Deposit Insurance Corporation (FDIC) announced the failure of four banks in California, Georgia, Idaho and Michigan. On May 1, 2009, the FDIC announced that three additional banks in Georgia, New Jersey and Utah had failed, bringing the total number of bank failures thus far in 2009 to 32. Bank failures to date in 2009 exceed the total for 2008 and represent the highest total since 1993. The failures consist primarily of smaller community banks. So far in 2009, the FDIC has announced bank failures almost every Friday. Banks have failed in 16 states across the country this year. Georgia currently leads the nation in the number of bank failures, followed by California. The recent failures and current trends suggest that bank closures are unlikely to slow down in the near future. (“FDIC Creates Bridge Bank to Take Over Operations of Silverton Bank, National Association, Atlanta, Georgia,” FDIC.gov, May 1, 2009; “2009 YTD Bank Failures Already Most Since 1993,” D&O Diary, April 27, 2009; “Three More Banks Fail,” CNNMoney.com, May 1, 2009)
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