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Publications
Credit Crunch Digest
October 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 recent significant decisions in civil litigation regarding subprime and other high-risk mortgages and related securities, new developments in criminal, regulatory and civil actions arising from the collapse of the auction rate securities market, the growing number of reported Ponzi schemes around the world, the status of civil and regulatory actions relating to the Madoff and Stanford Financial Ponzi schemes and continuing government efforts to ease the economic impact of the subprime crisis and credit crunch.
Litigation and Regulatory Investigations
Ponzi Schemes and Fraud Actions
Auction Rate Securities
Government and Regulatory Intervention
Litigation and Regulatory Investigations
Nomura Granted Dismissal in Lawsuit Arising From Mortgage Pass-Through Certificates
On September 30, 2009, Judge Richard Stearns of the U.S. District Court for the District of Massachusetts granted with prejudice the defendants’ motion to dismiss a purported securities class action complaint filed against Nomura Asset Acceptance Corporation, certain of its officers and directors, and various underwriters. In their amended complaint, the plaintiffs, who had purchased mortgage pass-through certificates issued by mortgage trusts established by Nomura, alleged that the defendants made false and misleading statements in connection with eight offerings of the certificates. Specifically, the plaintiffs alleged that the defendants made misleading statements regarding the loan underwriting standards for the originators of the mortgages held by the issuing trusts, the appraisal practices of those mortgage originators, the level of delinquencies for the mortgages in the issuing trusts and the ratings for the certificates.
In dismissing the amended complaint, Judge Stearns found that the named plaintiffs lacked standing to bring securities claims against the issuing trusts and the underwriter defendants for statements allegedly made with respect to all eight offerings because the named plaintiffs had only bought certificates from three of the eight issuing trusts. Additionally, Judge Stearns held that the plaintiffs failed to state a claim under Section 12 of the Securities Act because they did not allege that they purchased the certificates from the defendants. Instead, the plaintiffs alleged only that they “acquired” the certificates “pursuant and/or traceable to” the offerings. With respect to the plaintiffs’ specific allegations regarding the defendants’ misleading statements in connection with the mortgage originators’ loan underwriting standards, Judge Stearns found that the offering documents included sufficient cautionary language about “potential perils.” The court discredited the plaintiffs’ allegations regarding the rate of loan delinquencies by finding that the alleged misrepresentations were immaterial because the alleged percentage of delinquent loans held by the issuing trusts was insignificant. Finally, the court found that the plaintiffs did not allege sufficient facts to “support the inference that the ratings were compromised as of the dates” that the alleged misstatements became effective. Based on those findings, Judge Stearns held that the plaintiffs failed to sufficiently state claims for violations of the Securities Act. (“Subprime Lawsuit Against Mortgage Securitizer Dismissed,” D&O Diary, October 7, 2009; Plumbers Union Local No. 12 Pension Fund v. Nomura Asset Corporation, No. 08-10446-RGS (D. Mass. Sept. 30, 2009))
ERISA Lawsuit Against Mortgage Underwriter Partially Dismissed
On September 20, 2009, Judge S. Thomas Anderson of the U.S. District Court for the Western District of Tennessee granted in part and denied in part the defendants’ motion to dismiss an ERISA class action complaint filed against First Horizon National Corporation and its plan fiduciaries. The plaintiffs alleged that the defendants breached their fiduciary duties under ERISA by requiring the plan participants to invest in First Horizon stock in order to receive matching contributions and continuing to imprudently invest the plan in First Horizon stock. According to the plaintiffs, investments in First Horizon stock were imprudent after January 1, 2006 because at that time, the company was lowering its loan underwriting standards and increasing its involvement in the subprime and Alt-A loan markets.
The court granted the defendants’ motion to dismiss with respect to the plaintiffs’ allegations that the defendants breached their ERISA fiduciary duties by requiring plan participants to invest in First Horizon stock in order to receive matching contributions. Likewise, the court found that the plaintiffs failed to state a claim for breach of ERISA fiduciary duties regarding the defendants’ alleged lack of disclosures about the financial condition of First Horizon. The motion was denied, however, with regard to the plaintiffs’ claims that the defendants breached their fiduciary duties by failing to remove First Horizon stock from the plan after the time when it allegedly became imprudent for the plan to invest in the stock. The court explained that although the plan required the defendants to invest in First Horizon stock, a plan fiduciary can only follow the terms of a plan when the terms are consistent with their fiduciary duties under ERISA. (“Plaintiffs’ Extract Some Subprime Lawsuit Dismissal Motion Success,” D&O Diary, October 6, 2009)
Claims Against JPMorgan in WaMu ERISA Lawsuit Dismissed
On October 5, 2009, Judge Marsha Pechman of the U.S. District Court for the Western District of Washington granted motions to dismiss filed by JPMorgan Chase, National Association, and the former chief executive of Washington Mutual Inc. (WaMu), Kerry Killinger, in a lawsuit brought by former WaMu employees arising out of losses to their retirement accounts. The Federal Deposit Insurance Corporation (FDIC) seized WaMu and orchestrated the sale of WaMu’s assets, including Washington Mutual Bank, to JPMorgan in September 2008. The plaintiffs alleged that WaMu directors and members of the WaMu Plan Investment Committee and Plan Management Committee breached their fiduciary duties under ERISA by poorly managing and monitoring the plaintiffs’ funds and failing to advise the plaintiffs that “WaMu stock was increasingly risky well before the collapse.” Judge Pechman found that JPMorgan could not be held liable for the alleged mismanagement of the plaintiffs’ funds, which occurred before JPMorgan acquired WaMu’s assets, because such a holding would require the court to find that “the FDIC had the legal authority to transfer liability for prior 401(k) fund management with the purchase.” According to Judge Pechman’s order, the FDIC does not have such authority. The court allowed some of the plaintiffs’ claims to proceed against former members of the human resources committee of WaMu’s board of directors and the Plan Investment Committee and Plan Management Committee. (“WaMu Employees’ Lawsuit Against JPMorgan Dismissed,” The Seattle Times, October 7, 2009)
Upsurge in European Litigation Related to Complex Financial Products
The number of lawsuits filed against European banks for their roles in developing and selling complex financial products, including credit default swaps and collateralized debt obligations, increased dramatically during the first half of 2009 compared to the last six months of 2008. These lawsuits generally allege that banks that sold complex structured products to investors did not sufficiently disclose the products’ risks, which were hidden in the complexities of the products. The investors allege that they should not have been allowed to invest in the products because they did not understand the complexity. Additionally, many of the lawsuits involve disputes regarding the documentation for certain transactions. In the U.S., litigation arising out of complex financial products began to surge at the end of 2008, but similar litigation in Europe took longer to surface because of the comparatively higher litigation costs in Europe, where the losing party pays for both parties’ attorneys’ fees and costs. (“Complex Investments Spur Lawsuits in Europe,” The Wall Street Journal, September 28, 2009)
Ponzi Schemes and Fraud Actions
E&Y Bahamas Sued in Madoff-Related Action
On July 17, 2009, Ernst & Young’s (E&Y) Bahamas affiliate was named in a class action lawsuit filed in New York federal court by Tradex Global Master Fund SPC Ltd. in connection with Bernard Madoff’s Ponzi scheme. The complaint is filed on behalf of investors in the Santa Clara I Fund and alleges that E&Y Bahamas and its Cayman Islands affiliate, which acted as Santa Clara’s auditor, received $1 million in fees despite failing to properly audit the investment fund, which had all of its assets invested in Madoff’s scheme. The plaintiffs further allege that neither E&Y, Santa Clara’s investment manager Euro-Dutch Management, nor Euro-Dutch’s managing director Anthony Inder-Rieden, uncovered Madoff’s fraud, despite several red flags suggesting Madoff was operating a fraudulent scheme. The complaint alleges that “[E&Y] was also responsible for, complicit in and acquiescent to the issuance of the false and misleading statements and omissions” contained in the fund’s audited financial statements. Further, the plaintiffs allege that E&Y breached its duty to investors in Santa Clara because its audit opinions “never ‘fairly presented, in all material respects, the financial condition or results of the fund.’” Santa Clara is currently in liquidation in the Cayman Islands. (“Ernst & Young Defendant in Madoff Lawsuit,” The Tribune, August 25, 2009)
Half of Madoff’s Investors Did Not Lose Money, According to Federal Prosecutors
On September 22, 2009, federal prosecutors reported that a review by a court-appointed trustee of accounts held by Madoff investors indicates that approximately half of the customers did not lose any money as a result of the Ponzi scheme because they withdrew more money than they had originally invested with Madoff. Financial records apparently indicate that investors suffered net losses of $13 billion, and approximately 15,870 claims seeking recovery have been made to the trustee. Prosecutors advised a judge in New York federal court that an order of restitution is not necessary as Madoff’s identifiable assets totaling $1 billion will be distributed to investors through forfeiture requirements. Regulators continue to seek additional Madoff assets, which may have been funneled by Madoff’s business associates, including assets allegedly funneled by money manager Stanley Chais, who is accused of, among other things, securities fraud and unfair competition in a lawsuit recently filed by the California attorney general. Chais is already a defendant in several lawsuits filed by Madoff investors and has also been charged with civil fraud by the SEC in New York. (“Review Says No Net Loss for Some in Madoff Scheme,” The New York Times, September 22, 2009)
Prosecutors in Madoff Case May Hire Madoff Trustee to Help Distribute Forfeited Assets
In a recent court filing, federal prosecutors said that they may hire Irving Picard, the trustee for Bernard L. Madoff Investment Securities (BMIS), to help distribute forfeited assets to Madoff’s investors. Prosecutors say that hiring Picard would avoid duplicated efforts and be more efficient as Picard would work closely with the government and share his analyses of victim claims. Federal prosecutors’ plan to hire Picard was revealed in conjunction with a request by prosecutors to have U.S. District Judge Danny Chin allow the government to rely on forfeiture law rather than restitution statutes. In response to the government’s intention to retain Picard, a group of Madoff victims represented by attorney Helen Chaitman filed a motion asking Judge Chin to bar the appointment because Picard is allegedly using an erroneous formula to calculate losses. (“Madoff Prosecutors May Hire Picard to Help Distribute Assets,” Bloomberg.com, September 23, 2009; “Madoff Victims Make Problems for Picard,” New York Post, September 26, 2009)
Trustee Files Lawsuit Against Madoff Relatives
BMIS trustee Irving Picard filed a $199 million lawsuit against Madoff’s relatives, who are all former employees of BMIS. The complaint names Madoff’s brother, who served as the firm’s COO, Madoff’s sons, who served as co-directors of trading, and Madoff’s niece, who worked as the compliance director. Picard alleges that the relatives were “completely derelict in [their] duties and responsibilities. … As a result, they either failed to detect or failed to stop the fraud, thereby enabling and facilitating the Ponzi scheme.” The relatives’ management responsibilities included legal and regulatory compliance, customer relationships, and trading operations. According to the lawsuit, BMIS “operated as if it were the family piggy bank [and] [e]ach of the family defendants took huge sums of money out of [the company] to fund personal business ventures and personal expenses such as homes, cars and boats.” Family members continue to deny their involvement in the fraud. Picard’s suit against Madoff family members follows a lawsuit filed in July against Madoff’s wife, Ruth, seeking $44.8 million she allegedly transferred from the firm over a six-year period. (“Madoff Relatives Sued for $199 Million ,” CNNMoney.com, October 2, 2009; “Trustee Plans to Sue Madoff Family Members for $198 Million,” The New York Times, September 27, 2009.)
Chadbourne & Parke Added as Defendant in Stanford Lawsuit
On October 9, 2009, the plaintiffs in a lawsuit filed in federal court in Texas against Proskauer Rose and one of its former partners, Thomas V. Sjoblom, arising out of the defendants’ representation of Stanford Financial Group in a regulatory investigation, amended their complaint to name Chadbourne & Parke LLP as a defendant. The lawsuit alleges that Proskauer and Sjoblom aided and abetted Stanford’s fraud and conspired to obstruct an SEC investigation while representing Stanford in a regulatory investigation. According to the amended complaint Sjobolm began aiding Stanford in an “ongoing conspiracy … to evade regulatory scrutiny” while he was a partner at Chadbourne in 2005 and 2006. Sjobolm recently departed from Proskauer after the lawsuit was filed. (“Sjoblom, Sued by Stanford Investors, Leaves Proskauer,” Bloomberg.com, October 13, 2009)
FINRA-Appointed Committee Discloses Madoff and Stanford Missteps
On October 2, 2009, a committee appointed by Financial Industry Regulatory Authority Inc. (FINRA) announced the results of its review of FINRA’s internal investigation that failed to uncover the Ponzi schemes perpetrated by Madoff and R. Allen Stanford. The committee’s report details opportunities missed by FINRA examiners in connection with their investigations of Madoff and Stanford. With regard to Stanford’s $7 billion fraud, FINRA’s predecessor, the National Association of Securities Dealers (NASD), purportedly received reliable information from at least five sources between 2003 and 2005, which warned that the certificates of deposit sold to clients were potentially fraudulent. FINRA and NASD purportedly reviewed Madoff’s business every year for 20 years without uncovering the massive fraud.
In addition to outlining FINRA’s missteps, the report offers suggestions as to how FINRA’s program could be reformed. The report recommends that going forward, FINRA seek jurisdiction from Congress to regulate activities under the Investment Advisors Act of 1940. The agency also established a new Office of Fraud Detection and Market Intelligence “to make fraud detection a priority and bring together various investigative functions.” Finally, the report recommends that FINRA increase the number of staff members working on fraud detection. (“What They Missed: Where FINRA Missed Opportunities to Catch Madoff and Stanford,” Investment News, October 2, 2009; “FINRA Board Said to Debate Releasing Report on Madoff, Stanford,” Bloomberg.com, September 22, 2009)
Stock Broker Charged for Alleged Role in $250 Million Ponzi Scheme
On September 28, 2009, the SEC filed a civil complaint against Frank Bluestein in federal court in Michigan for his alleged role in a $250 million Ponzi scheme. Bluestein allegedly acted as the largest salesperson for E-M Management Company LLC, which was charged by the SEC in 2007 with fraud for selling shares of limited liability companies and falsely representing that those companies had profitable telecommunications contracts with casinos and resorts in Las Vegas. According to the complaint, between 2002 and 2007, Bluestein solicited more than 800 individuals, mostly older than age 50, to purchase approximately $74 million worth of securities issued by E-M. Bluestein allegedly lured potential investors by conducting investment seminars for elderly individuals in California and Michigan. The SEC alleges that Bluestein told investors that the E-M securities were low-risk investments and failed to disclose that he received $2.4 million in commissions from E-M and its operator. Although the complaint does not allege that Bluestein knowingly solicited investors for a Ponzi scheme, it alleges that he failed to conduct due diligence regarding the securities, which he represented as safe. (“UPDATE: SEC Charges Broker Tied to $250M Ponzi Scheme With Fraud,” The Wall Street Journal, September 28, 2009)
Bankruptcy Judge Freezes Assets of Madoff Money Manager
On October 7, 2009, U.S. Bankruptcy Judge Burton R. Lifland issued an order prohibiting Stanley Chais, a California money manager accused of funneling hundreds of millions from his clients to Madoff’s Ponzi scheme, from accessing funds held at various financial institutions. Chais and his wife are permitted to access only $100,000 until the freeze has been lifted to cover, among other things, legal expenses. BMIS trustee Irving Picard has sued Chais seeking to recover some of the funds for Madoff’s investors. Picard alleges that Chais collected more than $800 million in connection with his dealings with Madoff. The court ordered the freeze until October 22, 2009. (“Judge Freezes Assets of Madoff Figure Stanley Chais,” Los Angeles Times, October 9, 2009)
Auction Rate Securities
Federal Judge Issues Noteworthy Decision Dismissing ARS Action Against Raymond James
On September 17, 2009, Judge Lewis A. Kaplan of the U.S. District Court for the Southern District of New York granted defendants’ motion to dismiss with leave to amend in the auction rate securities (ARS) action against Raymond James Financial (Raymond James) and its subsidiaries. Judge Kaplan found that the complaint’s allegations were insufficient regarding misrepresentations made to plaintiffs or as part of a scheme by entities other than Raymond James’ retail sales subsidiary Raymond James Financial Services (RJFS). Judge Kaplan also found that the plaintiffs failed to plead scienter with particularity against all defendants. Specifically, Judge Kaplan found that the plaintiffs failed to sufficiently plead motive and opportunity and “conscious misbehavior or recklessness” because the court could not “infer that RJFS was aware that it was marketing ARS to potential investors fraudulently.” The court gave the plaintiffs until October 16, 2009 to submit an amended complaint. (“An Interesting Auction Rate Securities Suit Dismissal,” D&O Diary, September 23, 2009; “Bloomberg’s Morning Report on Trials and Other Litigation News, Bloomberg.com, September 21, 2009)
Federal Judge Dismisses ARS Action Against SunTrust
On September 24, 2009, Judge Thomas Thrash, Jr. of the U.S. District Court for the Northern District of Georgia granted defendants’ motion to dismiss an ARS action against SunTrust Banks without further leave to amend. The action alleged that SunTrust engaged in manipulative auction practices and its broker-dealer subsidiary sold plaintiffs ARS and failed to disclose the risks associated with those types of securities and the ARS market. Judge Thrash found that the plaintiffs’ allegations failed to meet the heightened pleading requirements applicable to securities fraud actions because the allegations were not pleaded with particularity. Although plaintiffs alleged that high corporate officials issued management directives and uniform sales materials regarding ARS practices, the court found that those allegations were not strongly supported in the amended complaint, which did not identify the officials who purportedly issued management directives and did not describe what documents pertaining to uniform sales practices had said and who at SunTrust issued the documents. Moreover, “none of the [p]laintiffs’ allegations mention a single communication from any high-level corporate officials, let along management directives or uniform sales materials.”
Further, Judge Thrash found that the plaintiffs’ allegations “did not give rise to a strong inference that the [d]efendants acted with an intent to defraud or with severe recklessness.” Although SunTrust was among companies investigated by the SEC in 2006 in connection with ARS practices, the court would not assume that executives continued to manipulate the ARS market and train brokers to continue fraudulent sales practices even after being investigated by the SEC. The opinion found that a more likely explanation for the plaintiffs’ allegations regarding SunTrust’s ARS practices is that high level corporate officials carelessly and negligently provided training to SunTrust representatives who sold ARS. As a result of the lack of training, SunTrust brokers may have exaggerated the securities’ benefits to customers. The plaintiffs’ allegations were more consistent with a negligent rather than fraudulent state of mind. (“More Subprime Lawsuit Dismissals,” D&O Diary, September 29, 2009;Martin Zisholtz v. SunTrust Banks, Inc., No. 1:08-CV-1287-TWT (N.D. Ga. Sept. 24, 2009))
Government and Regulatory Intervention
The Number of Small Bank Failures Growing
Since January 2009, the FDIC has seized 98 failing banks and placed their assets of those failed banks into the hands of other banks. While some of the larger U.S. financial institutions are growing stronger as the economy improves, smaller regional banks are just now being hurt by worsening commercial real estate loans on their balance sheets. Many regional banks made commercial real estate loans to home builders and other property developers to make up for lost business in the credit card and mortgage lending arena that was taken by larger competitors. Lending standards were eased during the real estate boom, and as a result, many smaller banks are being hurt by bets they made on new housing developments, strip malls and office projects.
Approximately $870 billion, roughly half of the banking industry’s $1.8 trillion of commercial real estate loans, are now held by small and medium-size banks. According to research firm Foresight Analytics, as a group, small banks have written off only a tiny percentage of the losses that many analysts expect them to incur. Foresight Analytics applied the commercial real estate loss assumptions that federal regulators used during stress tests last spring and found that as many as 581 small banks were at risk of collapse by 2011. Although some banking analysts are ready for a crisis akin to the savings and loan crisis two decades ago, Seila C. Blair, chair of the FDIC, announced recently that “we aren’t anywhere close to that today, and based on current projections, I don’t think we will get near that pace.” (“Small Banks Fail at Growing Rate, Straining FDIC,” The New York Times, October 12, 2009)
Regulation Proposed for Over-The-Counter Derivatives Three bills that address the largely unregulated $450 trillion over-the-counter derivatives market, which includes credit-default swaps, a financial instrument widely blamed for exacerbating the financial crisis, are currently before Congress. The Obama White House has proposed a set of new rules for the market, as has House member and chair of the Agricultural Committee Collin Peterson and House member and chair of the Financial Services Committee (which oversees the SEC) Barney Frank. Although each bill differs in some respects, all three proposals seek to bring accountability to the derivative markets by forcing more over-the counter derivatives trading onto exchanges or the equivalent. The proposals also seek to implement a central clearinghouse that would increase transparency by requiring more reporting on terms of contracts and trading. House leaders expect a vote on the proposal by next month, while the Senate expects a vote by early 2010. (“Derivatives Bill Addresses End User Concerns,” The New York Times, October 9, 2009)
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