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Publications
Credit Crunch Digest
August 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 to 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
California Pension Fund Sues Top Credit Ratings Agencies
The California Public Employees Retirement System (Calpers), the nation’s largest public pension fund, has filed a lawsuit in California alleging that its $1 billion in losses were caused by “wildly inaccurate” credit ratings on structured investment vehicles, including subprime mortgages, from the nation’s three leading ratings agencies. According to the complaint, Moody’s Investor Service, Standard & Poor’s and Fitch made negligent misrepresentations concerning the securities packages. Calpers, which provides retirement benefits to 1.6 million public employees in California, purchased $1.3 billion worth of the highly complex packages of securities in 2006, but the market for the securities collapsed in 2007 and 2008.
The lawsuit also contends that the ratings agencies continued to publicly promote structured investment vehicles even as they began to downgrade them. Calpers specifically alleges that Moody’s issued a report assuring investors of the viability of structured investments 10 days after Moody’s had downgraded some securitized packages in 2007. Like many other pension funds, Calpers has been heavily impacted by the market’s turmoil. The fund suffered a 27-percent decline in 2008, with its overall size shrinking to $183.3 billion from $253 billion one year earlier. (“Calpers Sues Over Ratings of Securities,” New York Times, July 14, 2009)
Ponzi Schemes
Madoff’s Ex-Auditor Pleads Not Guilty
On July 17, 2009, David Friehling of Friehling & Horowitz CPAs, the former auditor for convicted Ponzi-scheme operator Bernard Madoff, waived indictment and pleaded not guilty to criminal charges of securities fraud, aiding and abetting investment-adviser fraud and four counts of filing false audit reports with the U.S. Securities and Exchange Commission (SEC). Prosecutors from the U.S. Attorney’s Office in New York allege that Friehling failed to conduct meaningful, independent audits of Madoff’s firm, Bernard L. Madoff Investment Securities LLC (Madoff Investment), and falsely certified that he had done so. The government also claims that audits of Madoff’s firm failed to comply with generally accepted auditing and accounting standards and that the audit work papers maintained by Friehling were inadequate to support the audits’ findings. Friehling faces a statutory maximum of 105 years in prison if convicted. (“Madoff Ex-Auditor Friehling Enters a Plea of Not Guilty,” Wall Street Journal, July 18, 2009)
Trustee Sues Madoff’s Wife for $44.8 Million
On July 29, 2009, Irving Picard, the trustee liquidating Bernard Madoff’s investment business, sued the convicted Ponzi-schemer’s wife, Ruth Madoff, for $44.8 million in U.S. Bankruptcy Court, alleging that she was “massively enriched” by her husband’s $65 billion scheme. The trustee claims that Ruth Madoff profited from the fraud over the last six years, and any money that she made is recoverable under U.S. bankruptcy law. The complaint details 111 wire transfers from Madoff Investment to Ruth Madoff’s personal bank accounts or to companies in which she had invested. Picard alleges that some of that money was used to pay Ruth Madoff’s credit card bills and to buy a yacht for her family’s personal use. Picard has also filed lawsuits against Madoff’s biggest investors, including philanthropists and offshore hedge funds. (“Madoff Trustee Sues Con Man’s Wife for $44.8 Million,” Bloomberg, July 29, 2009)
Madoff Sparks Insurance Coverage Litigation
Bernard Madoff’s day in court ended with a 150-year federal sentence, but the litigation surrounding his Ponzi scheme is far from over as a new wave of insurance coverage litigation emerges. Two coverage complaints were filed in federal courts in Minnesota and New York in mid-July. The Minnesota case involves Upsher-Smith Laboratories, a pharmaceutical company that invested all of the funds in its profit sharing plan with Madoff Investment. As a result of the plan losses, the U.S. Department of Labor launched an investigation and demanded that the company restore all losses to the plan. Upsher-Smith then filed a claim with its “Employee Benefits Plan Administrative Liability” insurer and its crime insurer, but both have denied coverage.
Ann & Hope, Inc., which operates retail stores, filed a complaint in New York federal court against the company’s crime insurers. The complaint alleges that on August 14, 2008, Madoff’s firm caused $5 million to be transferred to Madoff’s account with JP Morgan, and as a result of Madoff’s fraud, the funds have been lost. The company filed a claim to its crime insurer, which has since denied the claim. (“Madoff – The Insurance Coverage Litigation Arrives,” D & O Diary, July 16, 2009)
Stanford Investors Sue Island Nation of Antigua
On July 13, 2009, several business investors sued the government of Antigua and Barbuda, claiming that the Caribbean nation helped R. Allen Stanford engineer his alleged $7 billion Ponzi scheme. Investors allege that the island government received money in exchange for helping the now-jailed financier conceal the financial condition of Antigua-based Stanford International Bank Ltd. The investors are suing for at least $8 billion in damages, which could be tripled under U.S. civil racketeering laws, and are seeking class action status on behalf of all people who were Stanford bank customers as of February 16, 2009. (“Stanford Investors Sue Antigua, Claiming Complicity,” Bloomberg, July 13, 2009)
Trio Arrested for Scamming Investors in British Ponzi Scheme
London police have arrested three men accused of masterminding one of Britain’s largest-ever Ponzi schemes and scamming more than 600 investors out of at least £80 million. Chelsea-based Indian entrepreneur Nandan Pruthi and his business partners, Kenneth Peacock and John Anderson, were arrested in May after London police conducted a series of raids. Investigators claim that the trio promised investors monthly payback rates between 8 and 13 percent. According to the Financial Services Authority, because none of the men were licensed to run collective investment schemes, no one who has lost money is entitled to government compensation. Victims of the massive scheme reportedly include former England cricketer Darren Gough, British sitcom “Rising Damp” actress Frances de la Tour and singer Jerome Flynn. (“Trio Accused of £80m Ponzi Scam,” The Observer (London), August 2, 2009); (“City Police Arrest Two Over £50m Fraud Scheme,” TimesOnline, May 21, 2009)
New Criminal Charges for Alleged WexTrust Ponzi Schemers
On July 31, 2009, federal authorities filed new criminal charges against two former WexTrust Capital LLC executives accused of running a $255 million Ponzi scheme that targeted Orthodox Jews. Last August, the SEC accused the executives of conducting at least 60 private placements and creating 150 entities purportedly to fund commercial real estate ventures, while they were actually diverting money to themselves or paying off earlier investors. Prosecutors from the U.S. Attorney’s office in New York are now charging the executives with three counts of securities fraud, two counts of mail fraud, one count of wire fraud and one count of conspiracy. In addition, federal prosecutors seek the return of the $255 million. Earlier this month, in the SEC case against WexTrust, a federal judge approved a receiver’s plan to liquidate the firm’s assets and distribute proceeds to victims. (“New Charges in Ponzi Fraud Targeting Orthodox Jews,” Reuters, July 31, 2009)
Madoff Discloses to Attorney Names of Fund Managers and Possible Accessories to Ponzi Scheme
On July 29, 2009, San Francisco attorney Joseph Cotchett interviewed Madoff regarding details of his $65 billion Ponzi scheme. Cotchett recently sued, among others, Madoff’s wife, sons and brother on behalf of investors and promised to consider dismissing Madoff’s wife from the suit if Madoff agreed to an interview. Madoff purportedly provided Cotchett with a detailed account of how he orchestrated the scheme, as well as the names of fund managers and other individuals who at the time either suspected or knew of the fraudulent scheme. According to Cotchett, several of these individuals have not yet been sued or connected to the fraud. Cotchett intends to amend two cases pending in New York state court within the next 30 days to include the names of certain fund managers who funneled money from investors to Madoff, and possibly remove others from the suit, including Madoff’s wife. Madoff’s wife has been named in other actions, including an action by the trustee charged with winding down Madoff’s former firm that seeks $44 million for investors and alleges that Madoff’s wife received the funds through fraudulent transfers. (“Madoff Gives Feeder Fund Managers’ Names to Lawyers,” Reuters, July 30, 2009)
Victims of Ponzi Scheme Claim SIPC Squandering Madoff Funds on Legal Fees
On August 3, 2009, victims of Madoff’s Ponzi scheme filed papers with the New York Bankruptcy Court claiming that funds being claimed by Irving Picard, the court-appointed trustee overseeing the winding down of Madoff’s former investment firm, are rightfully theirs. Picard has claimed more than $15 million in legal fees for 3 ½ months worth of work, which is approximately $1 million per week. Picard estimates that it could take up to five years to settle all of the Madoff claims and that fees could reach $250 million. More than 15,000 victims have filed a claim for compensation from the Securities Investor Protection Company of New York (SIPC). Helen David Chaitman, a lawyer representing investors, stated “[i]t is unconscionable that the SIPC should be squandering potentially hundreds of millions of dollars when it doesn’t even have enough money to compensate all the victims.” Under SIPC rules, each victim could be entitled to as much as $500,000. According to Chaitman, the SIPC needs approximately $7 billion to compensate victims, which they currently do not have. Mary Schapiro, head of the SEC, recently testified before Congress that there is not enough money to pay all of the customer claims. (“Madoff Funds ‘Squandered On Legal Fees’,” Daily Mail (London), August 5, 2009)
Auditors Win Crucial Court Ruling Limiting Liability in Madoff-Style Fraud Cases
Britain’s highest court ruled on July 30, 2009 that liquidators for Stone & Rolls, a trading company that folded in the 1990s, could not bring a claim for damages when the company itself was responsible for the fraud. Stone & Rolls’ liquidators argued that Moore Stephens, the company’s auditors, should have discovered the scheme because it was their job to uncover fraud. The law lords disagreed, applying an old legal principle that holds that “nobody can bring a cause of action based on his own criminal conduct.” The decision, which marks a victory for auditors, limits liability of accounting firms for Madoff-style fraud cases. Analysts predicted that large accounting firms would be targeted in lawsuits alleging that these firms failed to heed warning signs and discover fraudulent investment schemes. The decision will likely prevent creditors from pursuing lawsuits against accounting firms when a “powerful executive masterminded” the scheme. Lord Mance, in his dissenting opinion, stated that it is contrary to public policy to insulate an auditor from its failure to investigate and scrutinize the conduct of individuals responsible for orchestrating fraudulent investment schemes. (“Law Lords’ Ruling Limits Auditor Liability in Madoff-Style Frauds,” The Financial Times Limited, July 31, 2009)
Auction Rate Securities
TD Ameritrade Agrees to Return Millions to Investors
TD Ameritrade Inc. will return $456 million to auction-rate securities (ARS) investors as part of a settlement with New York’s attorney general. TD Ameritrade is the latest firm to agree to buy back billions of dollars worth of the illiquid securities. Citigroup Inc., Goldman Sachs Group Inc. and Fidelity Investments have already agreed to repurchase investor debt amid claims that they improperly touted the investments as safe, cash-like investments, while Charles Schwab has said that it will fight any lawsuit that the attorney general may file over its marketing and sales of ARS.
Banks managing auctions abandoned the $330 billion auction-rate market in February 2008, stranding thousands of investors who could no longer sell the securities at periodic biddings. This latest settlement will allow investors to sell back securities that they bought from TD Ameritrade before the market froze. TD Ameritrade will complete the buybacks within 75 days for account holders with $250,000 or less, and by March 2010 for all other eligible customers. The company has also agreed to compensate eligible customers who sold their securities below par by paying the difference between the par value and the sale price, plus interest. It also agreed to reimburse reasonable interest from affected customers who took out loans after February 13, 2008. (“TD Ameritrade to Pay $456 Million, End Cuomo Probe,” Bloomberg, July 20, 2009)
Citigroup Ordered to Pay $2.3 Million
On July 14, 2009, Citigroup Global Markets, Inc. (Citigroup) reached a settlement with the state of Pennsylvania over ARS, agreeing to pay the Pennsylvania Securities Commission $2.31 million and offering to buy back $978 million worth of ARS from 1,200 retail investors in the state who held the securities as of January 21, 2008. The Pennsylvania settlement is part of a larger settlement that Citigroup has reached with 12 states. Citigroup paid a $3.3 million fine and offered to repurchase $624 million in ARS from nearly 3,000 investors in New Jersey and agreed to pay a $309,000 fine in Delaware in April. (“Citigroup Reaches Auction Rate Securities Settlement with Pennsylvania,” NewsInferno.com, July 15, 2009)
Government and Regulatory Intervention
U.S. Lawmakers to Question Biggest Lenders in Fraud Investigation
Several of America’s biggest banks, including Goldman Sachs Group Inc. and Deutsche Bank AG, have been subpoenaed by Senate lawmakers who are seeking evidence of fraud in last year’s mortgage-market meltdown, according to reports. The Senate Permanent Subcommittee on Investigations has also reportedly issued a subpoena to Washington Mutual Inc., which was seized by regulators and is now largely owned by J.P. Morgan Chase & Co. The congressional investigation is reportedly focusing on whether internal communications, such as email, show that bankers had private doubts about whether mortgage-related securities were as financially sound as their public pronouncements suggested. Reports also suggest that several other financial institutions may have also received subpoenas and are part of the fraud probe. (“Senate Probes Banks for Meltdown Fraud,” Wall Street Journal, July 30, 2009)
SEC Revamps Policies to Protect Investors On July 14, 2009, SEC Chairwoman Mary Schapiro assured U.S. lawmakers that the agency had been revamping itself by buttressing enforcement efforts and taking initiatives to protect investors in the wake of both the financial crisis and the Madoff fraud. Schapiro reported that recent regulator proposals include restricting short-selling in down markets, strengthening oversight of mutual funds, tightening scrutiny of investment advisers and making it easier for shareholders to seat directors on company boards. The agency may also extend its work on tightening oversight of Wall Street’s credit rating agencies by preventing companies from shopping for favorable ratings for their securities and requiring companies to disclose all the preliminary assessments they receive. (“In Wake of Madoff, S.E.C. Head Says Agency Will Do More to Protect Investors,” New York Times, July 14, 2009)
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