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Publications
Credit Crunch Digest
November 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, 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
Government and Regulatory Intervention
Litigation and Regulatory Investigations
Former Bear Stearns Hedge Fund Managers Acquitted in Subprime Criminal Case
On November 10, 2009, after six hours of deliberation, jurors found Ralph R. Cioffi and Matthew M. Tannin not guilty of securities fraud for allegedly lying to investors about the state of the funds they oversaw. The case has been closely watched by the financial and legal communities, and the verdict is the first in a major criminal case stemming from the financial crisis. Prosecutors in the case relied heavily on e-mail messages between Cioffi and Tannin, messages the prosecution said showed the money managers knew their investments were souring but nonetheless continued to assure investors that the funds were sound. Defense lawyers in the case accused the prosecution of showing the e-mail messages out of context, and providing “misleading sound bites” to try to prove a criminal conspiracy.
In the end, jurors found that Cioffi and Tannin’s apparent salesmanship did not cross the line into fraud. “There was reasonable doubt on every charge. We just didn’t feel that the case had been proven,” said Ryan Goolsby, one of the jurors. Legal analysts note that the acquittals provide a cautionary tale for future white-collar prosecutions relying heavily on “smoking gun” e-mails. “The texting, twittering, Blackberry-toting jurors of today understand that an e-mail capturing a concern, doubt or momentary distress does not reflect thought over time, much less a vetted public statement,” said John Hueston, former federal prosecutor. (“Hedge Fund Managers at Bear Stearns Found Not Guilty of Fraud,” The New York Times, November 11, 2009; “U.S. Loses Bear Fraud Case,” The Wall Street Journal, November 11, 2009; “Former Bear Stearns Hedge Fund Managers Acquitted of Securities Fraud,” Los Angeles Times, November 11, 2009)
Security Class Action Against WaMu Allowed to Proceed
On October 27, 2009, Judge Marsha Pechman of the U.S. District Court for the District of Washington substantially denied the defendants’ motion to dismiss a securities class action complaint filed against former key officers and directors of Washington Mutual Bank (WaMu) as well as underwriters and accountants involved in offerings of WaMu securities. The lawsuit is a consolidation of three class action complaints that were filed against WaMu after it filed for bankruptcy in September 2008, marking the largest bank failure in U.S. history. Judge Pechman previously dismissed the plaintiffs’ initial consolidated complaint finding that it was disorganized and did not state cognizable claims under the Securities Act of 1933 (the Securities Act) and the Securities Exchange Act of 1934 (the Exchange Act). The plaintiffs’ amended complaint alleges that the defendants made false and misleading statements regarding WaMu’s risk management policies, appraisal process and underwriting standards for WaMu’s origination of mortgage loans, and WaMu’s financial results. The amended complaint cites four offerings of WaMu securities during 2006 and 2007 in which the bank raised approximately $4.8 billion.
In denying the defendants’ motion to dismiss, Judge Pechman found that the plaintiffs remedied the deficiencies in their original complaint, satisfied substantive pleading standards and presented cognizable claims against the defendants under both the Securities Act and the Exchange Act. However, Judge Pechman granted the defendants’ motion to dismiss claims based on an August 2006 offering because none of the named plaintiffs had purchased securities in that offering. (“Judge Lets Huge WaMu Securities Lawsuit Advance,” The Monterey County Herald, October 28, 2009; “Judge Lets WaMu Shareholder Suit Move Ahead,” Puget Sound Business Journal, October 28, 2009; “Renewed Dismissal Motion in WaMu Subprime Suit Substantially Denied,” D&O Diary, October 29, 2009)
CIT Group Files Chapter 11 Bankruptcy
On November 1, 2009, CIT Group Inc., a commercial lender, filed a voluntary petition for Chapter 11 bankruptcy in the U.S. Bankruptcy Court for the Southern District of New York. CIT predominantly provides loans to new and expanding businesses and short-term financing for retail manufacturers. During fiscal year 2009, CIT’s loan volume declined 88 percent from the prior year. From December 23, 2008, when CIT received approximately $2.33 billion from the Troubled Asset Relief Program (TARP), until it filed for bankruptcy protection, the price of CIT’s stock fell 83 percent. CIT’s bankruptcy filing followed efforts by CIT’s management to procure further government funding or a capital infusion from a private investor. However, CIT’s debt holders rejected an exchange offer that would have eliminated $5.7 billion worth of CIT’s debt.
According to CIT’s bankruptcy plan, debt holders of the company will receive 70 cents on the dollar as well as newly issued common stock of the company. Common and preferred shareholders will likely receive nothing in the bankruptcy reorganization. Thus, the U.S. Treasury Department has stated that it does not expect to recoup any of the TARP funds that it invested in preferred shares of the company. (“CIT Filing May Help Bondholders, Erase Taxpayer Stake (Update 1), Bloomberg.com, November 2, 2009; “CIT’s Long Goodbye,” CNNMoney.com, November 3, 2009; “Creditors Back CIT’s Bankruptcy,” The New York Times, November 2, 2009)
Ponzi Schemes and Fraud Actions
Florida Lawyer's Alleged Ponzi Scheme May Exceed $1 Billion
On November 9, 2009, federal prosecutors filed a civil complaint against Scott Rothstein, a high-profile South Florida attorney accused of concocting a Ponzi scheme that may have topped $1 billion. The civil complaint seeks forfeiture of more than $18 million in real estate owed by Rothstein, and prosecutors say criminal charges will also be filed within the coming weeks. The FBI says thousands of people across the U.S. may have been victimized in Rothstein's scheme in which Rothstein sold investors the right to collect legal settlements due to be paid within a fixed period of time.
Many of the alleged settlements may have been fictitious, said investigators. The civil complaint states that investors were promised profits as high as 20 percent or more, but it was all a lie according to the complaint, with Rothstein using new investors to pay earlier investors, backed up by false documents showing bank accounts containing fictional large sums. "The investigation has established that no such settlement agreements had ever existed and the entire investment scheme was a fraud," prosecutors said in the complaint. ("Feds Seize Assets of Fla. Lawyer in Ponzi Probe," The New York Times, November 9, 2009; "Lawyer Rothstein's Alleged Scam May Exceed $1 Billion," Bloomberg.com, November 12, 2009; "Alleged Ponzi Scheme Likely To Top $1 Billion," The Wall Street Journal, November 13, 2009)
Stanford Receiver Sues Former Employees for $11 Million
On October 15, 2009, Ralph Janvey, the receiver appointed to oversee R. Allen Stanford’s businesses, announced that he is seeking $11 million from two former employees of Stanford’s capital management firm in a lawsuit filed in Texas federal court. Janvey alleges that Christopher Aitkin received nearly $8.7 million and Stephen Thacker received nearly $2.6 million in November 2008, three months before federal charges were filed against Stanford as a result of his $7 billion Ponzi scheme. These payments represented work for merely three months and purportedly came from funds “not generated by legitimate business activities.” Janvey, who currently has $80 million under his control, intends to redistribute the $11 million to Stanford investors. (“2 Ex-Stanford Employees Sued for More Than $11M,” WAFB.com, October 15, 2009)
Investors in Stanford Ponzi Scheme Have Little Hope for Recovery
On October 22, 2009, Ralph Janvey met with investors to discuss developments in recovering funds invested in the Stanford Ponzi scheme. Prior to the meeting, Janvey received numerous complaints for failing to communicate with investors regarding the recovery effort and for attempting to collect more than $27 million in attorneys’ fees for his work overseeing Stanford’s businesses. On November 2, 2009, Janvey argued to a U.S. appeals court that he should be permitted to “claw back” millions of dollars from investors who withdrew their investment funds prior to the collapse of Stanford’s Ponzi scheme. Those investors, as well as the Securities and Exchange Commission (SEC), are arguing against the clawbacks, saying that they are illegal and target innocent investors. Other investors are working on obtaining insurance coverage from the Securities Investor Protection Corporation (SIPC), which insures securities at member firms for up to $500,000. The SIPC’s current position is that the certificates of deposit (CDs) issued by Stanford’s Antigua bank are not covered by the insurance. In addition, if insurance were available, it would be available only to investors who purchased the CDs through Stanford’s U.S. broker-dealer, which is a SIPC member. As such, foreign investors will not be eligible to recover under SIPC insurance. (“Stanford Investors Face Dwindling Hope for Recovery,” CNBC.com, October 25, 2009)
Federal Trial Begins in Alleged $3.65 Billion Ponzi Scheme
Minnesota businessman Tom Petters, currently on trial for allegedly orchestrating a $3.65 billion Ponzi scheme, is facing life in prison if convicted of the 20 counts against him, including wire fraud, money laundering and conspiracy. Petters built a small merchandise liquidation company into a diversified business conglomerate that owned businesses such as Polaroid. Prosecutors allege that Petters used his legitimate businesses to lure investors into loaning money that Petters said would be used to finance the purchase of electronic goods that would be sold to large stores for a profit. Instead of actually engaging in these electronic purchases, prosecutors allege that Petters instead used the money to finance his lifestyle and pay off earlier investors. Former federal prosecutor Doug Kelley says that the Petters case is more complicated than the Madoff fraud because Madoff kept accurate records, while Petters built a complex web of some 150 corporations now “in various stages of decrepitude.” (“Federal Trial Looms in Alleged $3.65B Ponzi Scheme,” The Associated Press, October 25, 2009)
Barry Tannenbaum Dubbed South Africa’s Bernie Madoff
South African officials have accused Barry Tannenbaum of perpetrating a Ponzi scheme and duping investors out of approximately $1.63 billion. South African authorities are currently seeking a global freeze on Tannenbaum’s assets. The businessman’s scheme purportedly involved enticing investors to “finance” the purchase of medical ingredients for a few weeks at a time. Tannenbaum then assured investors that these ingredients would be bought by drug firms at a significant mark-up, allowing him to repay investors at interest rates as high as 200 percent annually. Invoices to the drug firms were apparently falsified. Lawyers and investigators working for investors have compared Tannenbaum to Madoff, describing Tannenbaum’s fraud as a classic Ponzi scheme, which consisted of paying back old investors with the cash from new investors. Arrest warrants have been issued for Tannenbaum, who now lives in Sydney, Australia, as well as a lawyer linked to the purported scheme. (“S. Africa Seeks Global Freeze of Tannenbaum Assets,” Reuters, October 29, 2009)
German Prosecutors Investigate Possible Fraud by Hedge Fund Known As K1 Group
After reports surfaced that authorities in Europe and the U.S. were investigating whether a group of banks had been deceived in dealings with German hedge fund K1 Group, German prosecutors publicly announced that they are also investigating possible fraud and breach of duty by the founder of K1 Group, Helmut Kiener. Barclays, JP Morgan and BNP Paribas are among a group of banks that are believed to have lost tens of millions of dollars by providing credit to K1 Group. K1 Group is said to have $1.2 billion in assets and manages several specialist funds that invest in an underlying portfolio of hedge funds. It is reported that some of the banks that may be affected by the potential fraud within K1 Group have already recognized potential losses, limiting any impact on their bottom line. (“K1 Hedge Fund Probed as Barclays, JPMorgan Face Loss,” Bloomberg.com, October 28, 2009)
Richard Piccoli Sentenced to 20 Years in Prison
On October 21, 2009, U.S. District Court Judge William Skretny sentenced Richard Piccoli to 20 years in prison for a mail fraud charge resulting from his operation of a multimillion-dollar Ponzi scheme. Judge Skretny also imposed a five-year concurrent sentence for tax evasion. The 83-year-old Piccoli had argued for a sentence that would not require him to die in prison, but the judge rejected his defense. Piccoli took approximately $31 million from more than 800 investors between 2002 and 2009. Approximately 500 investors lost their investment when Piccoli used their funds to pay earlier investors. Authorities were able to recover only $7 million to reimburse victims of the scheme. In handing down the sentence, Judge Skretny stated that Piccoli “ran a ‘shameful, disgraceful and rather ruthless Ponzi scheme’” that consisted of recruiting investors through advertisements in Catholic newspapers that referenced clergy members as investors. (“‘Ruthless’ Ponzi Schemer Gets 20 Years in Prison,” Investmentnews.com, October 22, 2009)
Federal Prosecutors Make Arrests in Hedge Fund Related Insider Trading
Federal prosecutors recently arrested Raj Rajaratnam, the billionaire founder of Galleon Group, and five former directors at a Bear Stearns hedge fund, alleging that they operated a $20 million insider trading scheme, the largest insider trading scheme to date involving hedge funds. According to the complaint, the six defendants are charged with using insider information to trade shares of Google Inc., Hilton Hotels Corp., and Advanced Micro Devices. Rajaratnam allegedly received tips from insiders and others at hedge funds, investor relations firms, and companies including McKinsey, Intel, and IBM. According to the SEC, Rajaratnam established relationships with high-ranking corporate executives and insiders for the purpose of obtaining confidential details about quarterly earnings and takeover activity. Galleon, initially established as a hedge fund focusing on technology and health-care stocks, grew to more than $5 billion in 2001 from its start in January 1997. (“Hedge Fund Chief Is Charged With Fraud,” The New York Times, October 16, 2009; “Six Charged in Vast Insider-Trading Ring,” The Wall Street Journal, October 17, 2009; “Billionaire Hedge Fund Manager Arrested Over Alleged Insider Trading,” The Guardian, October 17, 2009; “Galleon’s Rajaratnam Charged in Biggest Hedge Scheme,” Bloomberg.com, October 16, 2009)
Longtime Madoff Accountant Pleads Guilty
On November 3, 2009, David Friehling, longtime auditor of the Madoff firm, pleaded guilty to three counts of obstructing the administration of tax laws, one count each of securities fraud and investment advisor fraud, and four counts of making false filings to the SEC. Friehling admitted to producing rubber-stamp audits that allowed Madoff to conceal his fraud. According to Friehling, he never adequately audited the Madoff operation because he trusted Madoff and had no suspicions that the figures Madoff produced were inaccurate. Friehling not only admitted to conducting inadequate audits, but also admitted to being an investor in Madoff’s firm. In pleading guilty, Friehling becomes the third person, along with Madoff and Frank DiPascali, to plead guilty in connection with Madoff’s fraud. DiPascali, a top aide to Madoff, admitted earlier this year to creating a fictitious paper trail of office records and customer accounts that helped deceive investors. (“Madoff’s Accountant Pleads Guilty in Scheme,” The New York Times, November 4, 2009)
Madoff Victims to Receive $500 Million From SIPC
On October 28, 2009, Irving Picard, the trustee for Bernard L. Madoff Investment Securities (BMIS) announced that the SIPC has agreed to advance more than $500 million to investors in Madoff’s Ponzi scheme. To date, Picard has identified $21.2 billion in cash investor losses, approximately $8 billion more than his original estimate of $13 billion. Picard has recovered $1.4 billion for the estate and expects to initiate additional lawsuits in the next six months in an effort to recover more money for victims, which have claimed approximately $4.43 billion in losses. The lawsuits Picard intends to file will consist of “clawback” suits against investors who withdrew their funds from Madoff’s firm in the years immediately preceding his arrest. Picard and the SIPC have received 15,974 customer claims, 11,000 of which are from investors who invested with Madoff indirectly through feeder funds. The SIPC has not paid any money to feeder-fund investors and Picard is currently evaluating how to handle these types of claims. According to the SIPC, the $534.3 million that the agency has already advanced in response to Madoff claims is more than the agency has advanced on all claims since its creation in 1970. (“Trustee: SIPC Will Advance $500 Million to Madoff Victims,” Law.com, October 30, 2009; “SIPC Sets Payouts in Madoff Scandal,” The Wall Street Journal, October 29, 2009; “Major Milestone: Over Half a Billion Dollars Advanced by SIPC So Far to Madoff Customers,” Reuters, October 28, 2009)
Madoff Expected the SEC to Catch Him Earlier
On October 30, 2009, SEC inspector general H. David Kotz released a 12-page summary of an interview with Madoff taken in June 2009 in which Madoff described his shock that the SEC failed to discover his fraud after Madoff told them “plainly suspect information.” In the interview, Madoff explained the he was constantly worried about getting caught by federal investigators. Madoff further revealed that he never dealt directly with Eric Swanson, a former SEC official responsible for helping to oversee the Madoff investigation at the time. Swanson later married Madoff’s niece, who had been working as a compliance officer at Madoff’s firm. In addition, Madoff alleged to have a close friendship with Mary Shapiro, the current chair of the SEC, but Kotz said that he has been unable to find any corroborating evidence to support Madoff’s claim. (“Madoff Shocked SEC Failed to Catch Him Earlier,” The Washington Post, October 31, 2009)
Picower Dies of Heart Attack
On October 25, 2009, Jeffrey Picower, longtime friend of Madoff, died of a heart attack in his Palm Beach, Florida home. Picower has been the subject of an ongoing criminal investigation regarding Madoff’s Ponzi scheme as possibly one of the biggest beneficiaries of the fraud. Picower and his wife began investing with Madoff in the 1970s and over the years, made more than $7 billion in profits. Irving Picard, the trustee overseeing the liquidation of Madoff’s assets, filed a lawsuit against the Picowers in May 2009, alleging that the Picowers were on notice of the fraud as early as September 2003 when Madoff was able to pay only a fraction of the profits sought by the Picowers. At the time of Madoff’s arrest in December 2008, one of Picower’s accounts was overdrawn by $6 billion, which would have suggested to the Picowers that something was wrong with their investment. The Picowers denied any knowledge of the fraud and alleged that they were deceived by Madoff like many other investors. Upon hearing of Picower’s death, Picard commented that he will continue to pursue litigation against the Picowers. (“Court Filing Indicates ’03 Problem in Madoff Investor Account,” The New York Times, October 1, 2009; “Pool Death Sets Back Fight for Madoff Compensation,” The Guardian, October 27, 2009; “Lawyer: Heart Attack Killed Picower,” The Wall Street Journal, October 27, 2009)
Europe’s Largest Bank Sued for Madoff Related Losses
The effects of the Madoff fraud continue to be felt worldwide as HSBC Holdings Plc, Europe’s largest bank, now faces lawsuits in Ireland by investors alleging that the lender failed in its duty as custodian for money lost in the $65 billion Ponzi scheme. Custodian banks serving European Union-regulated mutual funds are facing increased scrutiny as the European Union seeks to increase custodian banks’ responsibilities after the Madoff scandal. Custodians manage cash inflows and payments to investors, and investors in Ireland and Luxembourg have sued custodians, asking courts to break legal ground by holding custodians liable for billions of dollars in Madoff-related losses. Analysts have stated that decisions by Irish and Luxembourgish courts are significant as they are the top European countries for internationally sold funds. (“HSBC Faces Madoff-Linked Repayment Claims in Dublin,” Bloomberg.com, October 15, 2009)
Madoff Investors Sue the SEC
Two investors, who lost more than $2.4 million in the Madoff Ponzi scheme, have filed suit against the SEC under the Federal Tort Claims Act, asking that “the SEC be held accountable and for the federal government to do what the law says it must do: compensate the victims for its negligence.” The suit alleges that because the SEC failed to uncover the $65 billion fraud over the course of two decades, the government should compensate investors for the amounts they lost when the scheme was uncovered. In a press conference given by Howard Elisofon, the lawyer representing the Madoff victims, Elisofon said: “[i]nstead of watching the backs of [the victims] and the backs of other investors, the SEC—through its negligence—was effectively watching Bernie Madoff’s back.” Elisofon filed suit on behalf of investors after the SEC rejected their administrative claims. Analyst John Coffee of Columbia Law School has commented that the plaintiffs will likely not succeed in the suit, stating that “[t]he lawyers pursuing this action are equivalent to the people who bought a $1 ticket in the Irish sweepstakes.” (“Investors in Madoff Scheme Sue SEC,” The Financial Times, October 14, 2009)
Government and Regulatory Intervention
States Prepare to Bring Lawsuits Against Banks
In the wake of a June 2009 ruling by the U.S. Supreme Court that held that state governments could exercise their own supervision over banks that had previously been exclusively regulated by the federal Office of the Comptroller of the Currency (the OCC), several states’ attorneys general offices have indicated that they intend to file lawsuits against banks for alleged fraud related to those banks’ mortgage lending activities. The Supreme Court’s ruling reversed an expansion of federal authority over national banks that began in 2004 when the OCC promulgated two rule changes that effectively precluded state banking regulators from pursuing violations of state predatory lending laws by national banks and their subsidiaries. The lawsuit leading to the Supreme Court’s ruling arose from an investigation in 2005 by the New York attorney general into whether several banks operating in New York had violated the state’s fair lending laws. In response to the New York attorney general’s request for information from those banks, the Clearing House Association, which is a consortium of national banks, and the OCC filed a lawsuit to halt the investigation on the basis that state governments had no authority to regulate national lenders.
Since the Supreme Court’s ruling, several states have filed lawsuits against lenders, and other states are preparing to bring lawsuits based on allegations that banks violated state consumer fraud statutes by “marketing exotic loans that would prove impossible to pay back.” The U.S. House of Representatives is considering proposed legislation that would preempt state statutes and grant the federal government the power to prohibit states from regulating national banks in some circumstances. The Obama Administration has stated that it is opposed to such legislation. (“States Are Pondering Fraud Suits Against Banks,” New York Times, November 3, 2009)
FDIC Looks to Replenish Insurance Fund
With regulators closing banks at the fastest pace since 1992 during the savings-and-loan crisis, the FDIC faces the difficult task of keeping its insurance deposit reserve funded. The FDIC is required by law to rebuild the fund, which protects deposits up to $250,000 per account in the event of a bank failure, when the balance divided by insured deposits falls below 1.15 percent. The FDIC spent $2.5 billion to shut nine banks last week, with U.S. Bancorp acquiring banks owned by closely held FBOP Corp. “The failure of nine banks totaling almost $20 billion in assets is a further substantial blow to the deposit insurance fund,” said Kevin Petrasic, former special counsel at the office of Thrift Supervision. The FDIC has several options to replenish funds, including access to a $100 billion line of credit with the Treasury Department, and charging the banking industry a special fee in addition to the levies they already pay. Expecting tough times ahead, the FDIC has already asked banks to prepay three years of premiums to raise $45 billion for the fund. FDIC Chair Sheila Bair has stated, however, that the FDIC is prepared for the times ahead, explaining that “because the FDIC has many potential sources of cash, a negative fund balance does not affect the FDIC’s ability to protect insured depositors or promptly resolve failed institutions.” (“Bank Failures Buffeting FDIC Efforts to Bolster Insurance Fund,” Bloomberg.com, November 2, 2009)
House Panel Approves Hedge Fund Regulation Bill
The Private Fund Investment Advisors Registration Act, sponsored by Rep. Paul Kanjorski, a Democrat from Pennsylvania, was approved by the House Financial Services Committee 67 to 1. The bill would require hedge fund and other investment advisors overseeing private pools of capital to register with the SEC. Kanjorski explained that the bill attempts to shed light on the secretive world of hedge funds and private equity funds, and bring transparency to a large market in order to give regulators a better grasp of financial system risks. The committee bill exempts venture capital funds and funds with less than $150 million in assets. The bill is expected to get a full House vote sometime in November 2009. (“Congressional Panel Backs New Rules for Hedge Funds,” Reuters.com, October 27, 2009)
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