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Publications
Credit Crunch Digest
June 2010
In the June 2010 Edition:
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 decisions in civil litigation regarding subprime and other high-risk mortgages, the status of the Madoff, Rothstein and Starr schemes and related litigation, and the status of financial regulatory reform legislation in response to the subprime crisis and credit crunch.
Litigation & Regulatory Investigations
Fraud & Ponzi Schemes
Government & Regulatory Intervention
Litigation & Regulatory Investigations
Opinion Issued in Credit-Based Asset Servicing and Securitization Subprime Securities Lawsuit
On June 1, 2010, Judge Jed Rakoff of the U.S. District Court for the Southern District of New York (SDNY) issued an opinion substantiating a prior order issued on March 31, 2010, denying in part and granting in part the defendants' motions to dismiss a lawsuit filed against Merrill Lynch, Credit-Based Asset Servicing and Securitization, LLC and others. The plaintiffs alleged that the defendants violated federal securities laws by making certain misrepresentations regarding the mortgages underlying the securitizations that were purchased by the plaintiffs. In his June 1, 2010 opinion, Judge Rakoff granted the rating agency defendants' motion to dismiss, finding that rating agencies are not underwriters as defined by the Securities Act of 1933. Similarly, Judge Rakoff found that certain alleged underwriter defendants who originated the mortgages underlying the securitizations were not underwriters as defined by the Securities Act, but only "sponsors" of the offerings. With respect to the remaining alleged underwriter defendants, Judge Rakoff found that the plaintiffs had sufficiently alleged that the offering documents made misrepresentations regarding the mortgage originators' compliance with mortgage underwriting guidelines. However, the court dismissed the plaintiffs' claims in connection with 65 of the 84 securities offerings specified in the complaint, finding that the named plaintiffs lacked standing to bring those claims because they had not purchased securities in those offerings.
Additionally, Judge Rakoff found that the plaintiffs' claims were not barred by the statute of limitations as the defendants had argued in their motions to dismiss. According to the defendants, the plaintiffs were on inquiry notice prior to a year before the first complaint was filed because "questions about the bona fides of mortgage-backed securities were the subject of news reports, government investigations, public hearings and civil complaints." Judge Rakoff found that it was not appropriate to resolve the issue of inquiry notice at the motion to dismiss stage of the case. ("Two Subprime Suit Dismissal Motion Rulings," The D&O Diary, June 2, 2010; Public Employees' Retirement System of Mississippi et al. v. Merrill Lynch & Co. Inc. et al., 08-Civ-10841 (S.D.N.Y. June 1, 2010))
Court Denies Rating Agency Defendants' Demurrer in Subprime Lawsuit
On May 24, 2010, Judge Richard Kramer issued an opinion overruling the rating agency defendants' demurrer to negligence claims asserted by California Public Employees' Retirement System (CalPERS) in a lawsuit pending in California state court. CalPERS alleged that the rating agencies "did not have a reasonable basis" for assigning the highest ratings to securities issued by certain structured investment vehicles purchased by the plaintiffs. CalPERS alleged that it would not have invested in the securities if those securities had not received the highest ratings, and that the ratings were flawed because they did not account for the fact that the structured investment vehicles had concentrated risk in certain types of residential mortgages and residential mortgage backed securities.
The rating agency defendants argued on demurrer that the ratings are constitutionally protected by the First Amendment guarantee of free speech. Judge Kramer rejected that argument, finding that the ratings are not a protected "issue of public concern," but "an economic activity designed for a limited target for the purpose of making money." Judge Kramer also rejected the rating agency defendants' arguments that the plaintiffs' claims are barred by the New York Martin Act or the Credit Rating Agency Defense Act. Judge Kramer granted the defendants' demurrer with respect to the plaintiffs' claim for negligent interference with prospective economic advantage, but he granted the plaintiffs leave to amend their complaint to adequately allege that claim. ("Another Court Rejects Rating Agencies' First Amendment Defense," D&O Diary, June 7, 2010; California Public Employees' Retirement Systems v. Moody's Corp., et al., Case No. CGC-09-490241 (Cal. Sup. Ct. June 1, 2010))
Lawsuit Against JA Solar Arising Out of Lehman Exposure Will Proceed
On May 17, 2010, Judge John Koeltl of the SDNY issued an order denying the defendants' motion to dismiss a securities lawsuit filed against JA Solar Holdings Co. Ltd. and certain of its officers and directors. The lawsuit arises out of JA Solar's alleged misrepresentations regarding its exposure to Lehman Brothers Holdings Inc. (Lehman). The plaintiffs filed a complaint in December 2008, after JA Solar announced in November 2008 that it was writing down the value of a $100 million note that it had purchased in mid-2008 from Lehman Treasury, a Dutch subsidiary of Lehman. The principal on the note was supposedly 100 percent protected and guaranteed by Lehman. The plaintiffs allege that the defendants did not reveal the purchase of the note during an August 2008 conference call. Instead, according to the complaint, the defendants revealed only that Lehman was managing JA Solar's cash. Additionally, the plaintiffs allege that the defendants misrepresented in a press release issued on the day after Lehman filed for bankruptcy protection that the defendants expected the principal and interest on the note to be returned to JA Solar on October 9, 2008, the maturity date of the note.
The defendants argued in their motion to dismiss that they had no duty to disclose the purchase of the note during the August 2008 conference call, and they adequately disclosed information about the note in September 2008. Judge Koeltl found, however, that the plaintiffs adequately alleged actionable misrepresentations by the defendants in both the August 2008 conference call and the September 2008 press release. Specifically, Judge Koeltl found that the plaintiffs adequately alleged that JA Solar's CEO misrepresented JA Solar's relationship with Lehman and the amount of protection provided for the note after Lehman filed for bankruptcy. Judge Koeltl also found that the plaintiffs had adequately alleged scienter by stating facts to show that the defendants had knowledge contrary to the alleged misrepresentations regarding both JA Solar's exposure to Lehman, and the principal protection of the note after Lehman filed for bankruptcy. ("Dismissal Motion Denied in Case Alleging Lehman-Related Exposure," D&O Diary, May 18, 2010; Ellenburg, et al. v. JA Solar Holdings Co. Ltd., et al., 08-Civ-10475 (S.D.N.Y. May 17, 2010))
Fraud & Ponzi Schemes
Celebrity Investment Advisor Charged in Ponzi Scheme
On May 27, 2010, Kenneth Starr (not the same Kenneth Starr who served as a special prosecutor during the Clinton administration), a New York investment advisor to well-known Hollywood celebrities, was arrested on charges of running a $30 million Ponzi scheme. According to the criminal complaint, Starr, through his investment advisory firms Starr Investment Advisors and Starr & Co., gave financial advice to wealthy celebrities, including Martin Scorsese, Wesley Snipes, Sylvester Stallone, Goldie Hawn and Uma Thurman. Starr allegedly marketed "his services as an account and financial advisor to clients, gained control over millions of dollars belonging to his clients, and then misappropriated millions of dollars of his clients' assets for his own personal use," including a sprawling $7.5 million Upper East Side Manhattan condominium. According to the complaint, at one point Starr managed assets in excess of $700 million. Starr has been denied bail and deemed a "serious flight risk." The case is United States v. Kenneth Starr, et al., in the U.S. District Court for the SDNY, No. 10-MJ-1135. ("Starr, Investment Advisor to Stars, Denied Bail in $30 Million Ponzi Scheme," International Business Advisor, May 28, 2010)
European Authorities Resist U.S. Trustee's Efforts to Recover Assets From Fund Linked to Madoff Ponzi Scheme
Authorities in Luxembourg, charged with liquidating funds linked to Bernard Madoff's fraudulent Ponzi scheme, have announced that they will oppose any efforts by Irving Picard, the U.S. trustee overseeing the liquidation of Bernard L. Madoff Investment Securities LLC (BLMIS), to recover assets from LuxAlpha Sicav-American Selection that would reduce recoveries for European investors. LuxAlpha had approximately $1.4 billion in net assets in November 2008, before Madoff was arrested and charged with operating a massive Ponzi scheme. Picard is reportedly seeking the return of approximately $752 million that BLMIS allegedly paid to LuxAlpha. In a letter sent to investors on May 20, 2010, the liquidators of LuxAlpha stated that Picard is taking steps that could have a "significant effect" on recoveries. The letter also stated that the LuxAlpha liquidators will resist any requests from Picard for documents to identify LuxAlpha investors. ("Madoff Liquidators Clash Over LuxAlpha Fund Assets (Update 2)," Bloomberg.com, June 7, 2010)
New York Attorney General Brings Lawsuit Against Ivy Asset Management for Involvement With Madoff
On May 11, 2010, New York Attorney General Andrew Cuomo filed a civil lawsuit in New York state court against Ivy Asset Management LLC, a subsidiary of Bank of New York Mellon Corp., and two of its former officers alleging that the defendants knew "disturbing facts" regarding Madoff's fraudulent Ponzi scheme, but concealed those facts and continued to recommend clients to invest with Madoff. Ivy began investing with Madoff in October 1987. The complaint does not allege that the defendants knew that Madoff was operating a Ponzi scheme, but it alleges that the defendants gradually began to have doubts about how Madoff could have generated the returns that his firm reported using the options trading strategy that it purported to use. Additionally, the lawsuit alleges that the defendants were aware as early as 1998 of an "obviously false" explanation regarding Madoff's options trading strategy. However, according to the lawsuit, the defendants failed to reveal any of their reservations regarding Madoff to Ivy's clients in an effort to generate fees and maintain their standing in the asset management industry. ("Madoff Fallout Ensnares Ivy, Former Officers," The Wall Street Journal, May 12, 2010)
Convicted Ponzi Schemer Rothstein Now Working for FBI
Scott Rothstein, the Florida lawyer who pleaded guilty in January 2010 to multiple counts of fraud in connection with his $1.2 billion Ponzi scheme, has revealed that for the past few months he has been working undercover for the FBI. The admission was made in legal documents filed with the court in a bid to reduce the federal prison sentence Rothstein will receive. According to Rothstein's lawyer, "Mr. Rothstein acknowledges that he not only stole other people's monies, he also used it to corrupt the political process and enhance his power for personal gain." Rothstein donated more than $600,000 to the Republican Party of Florida and $200,000 to the Florida Democratic Party. According to reports, the case against Rothstein is one of several state and federal investigations that have led some of Florida's best-known figures to obtain counsel and answer questions before grand juries. One of those investigations led to the indictment of former Republican Party Chair Jim Greer on multiple counts of fraud. Rothstein faces a possible prison sentence of 100 years. ("Ponzi Schemer Scott Rothstein Says He's Been Working Undercover for FBI," St. Petersburg Times, June 7, 2010)
Government & Regulatory Intervention
Senate Passes Financial Reform Bill
On May 20, 2010, the Senate passed a financial regulatory bill that is being described as the most sweeping regulatory overhaul since the aftermath of the Great Depression. The vote was 59 to 39, with four Republicans joining the Democratic majority, casting votes in favor of the bill. Congressional leaders and the Obama administration must now work to combine the Senate bill with a House version passed in December. The Senate bill seeks to curb abusive lending and to ensure that troubled companies, no matter how big or complex, can be liquidated at no cost to taxpayers. Additionally, the Senate bill would create a "financial stability oversight council," establish new rules on the trading of derivatives and require hedge funds and most other private equity companies to register for regulation with the Securities and Exchange Commission. Although the House and Senate bills are similar, the House version would create a $150 billion fund, financed by a fee on big banks, to help pay for liquidation of failing financial companies (a provision that was not included in the Senate bill). According to lawmakers, the bills will be reconciled in a formal conference proceeding, possibly televised. ("Bill Passed in Senate Broadly Expands Oversight of Wall St.," The New York Times, May 20, 2010)
Financial Crisis Inquiry Commission Issues Subpoena to Goldman Sachs
On June 7, 2010, the Financial Crisis Inquiry Commission issued a subpoena to Goldman Sachs for "failing to comply with a request for documents and interviews in a timely manner." The Financial Crisis Inquiry Commission, established by Congress to investigate the causes of the current financial crisis, is required to deliver a final report by December 2010. The commission has been criticized in the past for not being aggressive enough in its use of the subpoena powers granted to it by Congress last year. According to a spokesman for the commission, "Goldman Sachs has not, in our view, been cooperative with our requests for information, or forthcoming with respect to documents, information or interviews." Sources involved with the investigation say that Goldman has already provided more than 20 million pages of documents, and the commission has already begun interviewing witnesses on a range of issues, including derivatives. ("Financial Panel Issues a Subpoena to Goldman Sachs," The New York Times, June 7, 2010)
Investors Help Ease the Burden Off the FDIC
A rise in banking takeovers and investments suggests that stronger financial institutions and private investment firms see value in the current state of American banking. Now that some troubled banks are being taken over by private investors rather than closed by the government, the pressure on the Federal Deposit Insurance Corporation (FDIC) is beginning to ease. Although many more bank failures are expected, particularly among small and midsize lenders exposed to commercial real estate, the worst may be over. According to reports, one reason troubled banks are surviving is that other banks, as well as investors who specialize in companies in distress, are swooping in, looking to buy lenders inexpensively, with little or no government help. "We are not in any danger of running out of failed banks," said Wilbur L. Ross, a prominent bank investor. "The only question is how much investor demand there will be." ("Investors Ease Strain on F.D.I.C.," The New York Times, May 19, 2010)
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