Credit Crunch Digest
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 the rejection of the Citigroup Mortgage settlement; Lehman Brothers investors’ settlement with Underwriters; Morgan Stanley’s collateral debt obligation lawsuit; the Madoff trustee’s lawsuit against Credit Suisse; Madoff investors’ lawsuit against Bank of New York Mellon; the status of the Madoff trustee’s attempt to recoup lost funds on the anniversary of Madoff’s arrest; and the status of Dodd-Frank reforms.
Litigation and Regulatory Investigations
Fraud and Ponzi Schemes
Government and Regulatory Intervention
Litigation and Regulatory Investigations
Judge Rejects Citigroup Mortgage Settlement, SEC Practices Sharply Questioned
Following a contentious mid-November hearing, Federal District Court Judge Jed Rakoff ultimately rejected a $285 million SEC settlement with Citigroup for its alleged sale of bad mortgage-related securities that defrauded investors by $1 billion. In his November 28, 2011 ruling, Judge Rakoff questioned the SEC’s longstanding policy of allowing financial institutions to settle enforcement actions without admitting liability. In finding the settlement terms insufficient, Judge Rakoff reasoned that he “has not been provided with any proven or admitted facts upon which to exercise even a modest degree of independent judgment…” A trial is currently scheduled for July 16, 2012, but it appears that the parties may attempt to reach a revised settlement to avoid such a trial. Both Citigroup and the SEC maintain that the proposed settlement was both fair and reasonable.
Judge Rakoff, who has rejected SEC settlements with banks in the past, found that if the allegations against Citigroup “are true, then this is a very good deal for Citigroup.” He continued stating that, “[e]ven if they are not true, it is a mild and modest cost of doing business.” Judge Rakoff criticized the SEC’s approach in his opinion, stating that “[h]ere an agency of the U.S. is saying, in effect, ‘although we claim that these defendants have done terrible things, they refuse to admit it and we do not propose to prove it, but will simply resort to gagging their right to deny it.’” Judge Rakoff further described Citigroup as a “recidivist” violator and flatly rejected the government’s position that the court should defer to the SEC’s judgment on the fairness of a settlement, despite the established practice of such settlements in which the defendant “neither admits nor denies” the allegations. (“SEC Policy Challenged in Judge's Rejection of $285 Million Citigroup Deal," Bloomberg, November 28, 2011).
Lehman Brothers Investors Settle Claims Against Underwriters
Investors have agreed to settle securities claims against more than 30 underwriters who underwrote in excess of $31 billion in debt and equity offerings for Lehman Brothers, the collapse of which was a key chapter in the global financial crisis. The plaintiffs in these actions alleged that the underwriters, which included Bank of America and units of Bank of New York Mellon, Citigroup and Wells Fargo, assisted Lehman Brothers in making misstatements about its finances prior to its implosion and eventual bankruptcy filing. The proposed settlement still requires district court approval.
Lehman Brothers also appears on the verge of exiting bankruptcy protection, as the bankruptcy court approved its plan to end its record-shattering Chapter 11 bankruptcy. An investor lawsuit continues against Lehman Brothers’ former auditor Ernst & Young and certain additional underwriters. Lehman Brothers previously sought a $90 million settlement with former directors and officers, including former CEO Richard Fuld, bringing the amount of settlement in the case to $507 million. (“Lehman investors, underwriters in $417 million accord,” Reuters, December 6, 2011).
Morgan Stanley Denies Allegations, Seeks Jury Trial in CDO Fraud Case
Morgan Stanley & Co. Inc. denied claims of fraud by 18 Singaporean investors who allege that packaged collateral debt obligations (CDOs) were designed to fail. Morgan Stanley’s December 5, 2011 answer to the lawsuit contested all claims, asserting that the company acted with “reasonable care and due diligence” in the marketing of the CDOs. Morgan Stanley demanded that the case, in which the plaintiffs allege $154.7 million in damages, be heard by a jury.
The plaintiffs allege that Morgan Stanley took a short position against the CDOs, which were packaged with subprime mortgage debt, Icelandic banks’ paper and other companies in which the plaintiffs contend that Morgan Stanley knew were troubled. Morgan Stanley argued that the plaintiffs were sophisticated investors who “knowingly” and “voluntarily” assumed the risks “inherent in the investments at issue.” The plaintiffs suffered nearly a complete loss on their investments in the 2008 market downturn.
Previously, the district court overseeing the case dismissed certain claims against Morgan Stanley, including breach of fiduciary duty and negligent misrepresentation, but the court allowed claims for fraud and breach of good faith to remain. The district court also rejected Morgan Stanley’s request to have the case tried in Singapore. (“Morgan Stanley Strikes Back at CDO Fraud Claims,” Law360.com, December 6, 2011).
Fraud and Ponzi Schemes
Madoff Trustee Picard Seeks $375 Million From Credit Suisse
On Monday, December 12, 2011, Madoff trustee Irving Picard filed a lawsuit against Credit Suisse Group AG in the U.S. Bankruptcy Court in Manhattan alleging it and several of its affiliates harbored money that belonged to Madoff’s estate. Specifically, Picard is attempting to recover $375 million, representing funds that were deposited with Credit Suisse through two of Madoff’s largest feeder funds, Fairfield Sentry Ltd. and Kingate Global. Both of the funds are currently undergoing liquidation following the collapse of Madoff’s Ponzi scheme. Steven Vames, spokesperson for Credit Suisse, issued the following statement: “While we are still reviewing the complaint, there is no allegation that [Credit Suisse] did anything wrong . . . This is simply another of the numerous claims the trustee has filed in an attempt to claw back further funds.” (“Madoff Trustee Sues Credit Suisse for $375 Million,” The Wall Street Journal, December 13, 2011).
The Rye Funds File Suit Against Bank of New York Mellon
On December 9, 2011, a lawsuit styled In re: Tremont Securities Law, State Law and Insurance Litigation v. Bank of New York Mellon Corp. was filed in New York State Supreme Court against Bank of New York Mellon and its BNY Alternative Investment Services unit alleging gross negligence in the administration of three separate Rye funds. Specifically, the complaint alleges the defendants “turned a blind eye to Madoff’s scam and reaped tens of millions of dollars in fees from the Rye funds, whose assets were entrusted to the BNY defendants and ultimately plundered by Madoff[.]” In the lawsuit, plaintiffs seek both compensatory and punitive damages. Representatives on behalf of BNY have declined to comment on the lawsuit. (“Bank of New York Mellon Sued for Negligence Over Madoff,” Bloomberg Businessweek, December 12, 2011).
On Three-Year Anniversary of Madoff Arrest, Madoff Trustee Picard Still Faces Hurdles
December 10, 2011, marked the three-year anniversary of Bernard L. Madoff’s arrest. To date, almost $11 billion of the $18 billion in estimated losses has been recovered by Madoff trustee, Irving Picard. Nevertheless, Picard faces challenges in 2012. First, Picard needs to appeal lower court rulings that could reduce any future recovery by approximately $11 billion. These lower court rulings involve three general issues: first, whether Picard has the legal right to sue Madoff’s bank and/or other third parties on behalf of defrauded investors; second, whether there is a safe harbor that would protect investors from having to turn over profits made prior to the collapse of the Ponzi scheme; and finally, the question remains regarding the level of proof Picard needs to show to establish that sophisticated investors were “willfully blind” to the fraud.
Picard has also sustained congressional and public criticism with respect to his “claims formula.” Specifically, in approving the 2,425 out of 16,519 claims filed, Picard reviewed only the net figures, denying claims by those who ultimately withdrew more money than they had invested with Madoff. Last February, however, Rep. Scott Garret (R-NJ) introduced a bill that would require the trustee in a brokerage-firm bankruptcy to accept claims on the final account statements, rather than the net cash they lost. The same bill would also proscribe the trustee from recovering the “fictional profits” the investor received. (“The Lasting Shadow of Bernie Madoff,” The New York Times, December 10, 2011).
Government and Regulatory Intervention
Proposed FDIC Rule Clarifies Regulation of Mutual Insurers Under Dodd-Frank
A proposed rule issued by the Federal Deposit Insurance Corporation (FDIC) makes clear that regulation of mutual insurers will be left to state oversight and not expanded federal regulation pursuant to Dodd-Frank. The National Association of Mutual Insurance Companies (NAMIC) has been warning against “duplicative and unnecessary regulation” since the inception of financial reform following the 2008 financial crisis. The proposed rule specifically states that a mutual insurance holding company is defined as an “insurance company” under Dodd-Frank. This common-sense classification is extremely important because being defined as an “insurance company” means that mutual holding companies will remain under regulatory jurisdiction of the states, and not subject to the FDIC’s orderly liquidation authority created under Dodd-Frank.
“Congress was very clear in crafting the Dodd-Frank Act that it would defer to the state-based regulatory system for property/casualty insurance.... Today’s proposed rule will ensure that the FDIC remains true to that intent,” said Charles M. Chamness, president and CEO of NAMIC. (“Mutual Insurers Pleased With FDIC Rule Clarifying Dodd-Frank,” Insurance Journal, December 13, 2011).
FDIC Proposes Alternative Rating Methods
On December 7, 2011, FDIC board members voted 3-0 to propose three methods that could replace banks’ current reliance on credit ratings to value debt. As part of the Dodd-Frank reforms, banks are directed to use an alternative to credit ratings to value debt in their trading books. The FDIC proposals were crafted in conjunction with the Federal Reserve and the Office of the Comptroller of the Currency. The proposals would affect the amount of capital a bank has to reserve against potential losses.
After the financial crisis of 2008, many lawmakers faulted rating agencies such as Standard & Poor’s and Moody’s Corporation in failing to adequately assess the risk posed by securitized debt tied to the real estate market. Thus, the Dodd-Frank reforms call for an alternative method to assess credit rating. According to FDIC acting chair Martin Gruenberg, “[t]he agencies have developed credit ratings replacement alternatives that use readily available and objective data.” The alternative rating methods would only be necessary for “a select few of the largest [banking] institutions.” That is, those lenders that have more than $10 billion in total trading assets and liabilities or more than 10 percent of their total assets in trading liabilities. (“FDIC Seeks Comment on Alternatives to Ratings for Grading Debt,” Bloomberg, December 7, 2011).