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Publications
Credit Crunch Digest
March 2010
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 release of the Lehman bankruptcy examiner’s report, recent significant decisions in civil litigation regarding subprime and other high-risk mortgages, the status of the Stanford, Madoff and Petters Ponzi schemes and related litigation, and the status of financial regulatory reform legislation in response to the subprime crisis and credit crunch.
Litigation and Regulatory Investigations
Fraud and Ponzi Schemes
Government and Regulatory Intervention
Litigation and Regulatory Investigations
Bankruptcy Examiner Releases Report Detailing Lehman Collapse
On March 11, 2010, the examiner appointed by the U.S. trustee in January 2009 to investigate the causes of Lehman’s bankruptcy released a voluminous report detailing the accounting practices of Lehman Brothers Holdings Inc. that led to the company’s collapse in September 2008. The bankruptcy examiner’s report states that Lehman engaged in “materially misleading accounting gimmicks” and “financial engineering” to conceal its debt and approximately $50 billion of troubled assets in the months immediately preceding its bankruptcy filing. Much of the report focuses on a program known internally at Lehman as “Repo 105,” in which senior Lehman officials secretly transferred billions of dollars off Lehman’s balance sheet. The report explains that under Repo 105, Lehman sold illiquid real estate-related securities at the end of a financial quarter, but planned to buy back the securities only a few days after the start of the next financial quarter.
According to the report, Lehman’s accountants at Ernst & Young were aware of misleading accounting maneuvers at Lehman, and Richard Fuld, the former chief executive officer of Lehman, certified misleading reports. In a statement released by his attorney in response to the report, Fuld denied any knowledge of or involvement in Repo 105. The report, however, characterizes Fuld as “at least grossly negligent” and states that senior Lehman executives engaged in “actionable balance sheet manipulation.” Although the report does not explicitly conclude that Lehman executives violated U.S. securities laws, it states that “colorable claims” could be made against some former Lehman executives and Ernst & Young. (“Report Details How Lehman Hid Its Woes as It Collapsed,” The New York Times, March 11, 2010)
Lehman Mortgage-Backed Securities Lawsuit Dismissed
On February 17, 2010, Judge Lewis Kaplan of the U.S. District Court for the Southern District of New York substantially granted the individual defendants’ motions to dismiss the plaintiffs’ consolidated complaint in a purported securities class action brought against Structured Asset Securities Corporation, a subsidiary of Lehman that issued mortgage-backed securities (MBS) in August 2005 and August 2006. The plaintiffs alleged that the originators of the loans that backed the MBS failed to comply with the underwriting standards described in the offering documents for the MBS and the ratings of the MBS were misleading because the credit enhancements supporting the loans were insufficient. The plaintiffs also alleged that the offering documents for the MBS failed to disclose that the rating agencies that rated the MBS were also involved in structuring the MBS. Thus, according to the plaintiffs, the rating agencies had a conflict of interest.
Judge Kaplan found that the plaintiffs’ claim that the offering documents failed to disclose the rating agencies’ conflict of interest was not actionable because it was “publicly known” that the rating agencies “operated under a conflict of interest” since they were paid by the issuers of the securities that they rated. Additionally, Judge Kaplan found that the rating agencies’ alleged role in structuring the MBS was immaterial and the plaintiffs’ allegations regarding misrepresentations about the form of credit enhancement supporting the loans were statements of opinion. Judge Kaplan did not dismiss the plaintiffs’ claims regarding the defendants’ failure to disclose in the offering documents that the loan originators departed from the stated underwriting guidelines. (“Rating Agencies’ Alleged Conflicts of Interest Held Immaterial,” The D&O Diary, March 1, 2010; In re Lehman Brothers Securities and ERISA Litigation, No. 09-MD-2017 (S.D.N.Y. February 17, 2010))
Credit Suisse Subprime Lawsuit Will Proceed
On February 11, 2010, Judge Victor Marrero of the U.S. District Court for the Southern District of New York granted the plaintiffs leave to file a second amended complaint in a purported securities fraud class action filed against Credit Suisse Global. Judge Marrero had previously dismissed the plaintiffs’ complaint, which alleged material misrepresentations regarding Credit Suisse’s asset valuation system, internal controls and exposure to subprime mortgage related losses. In dismissing the plaintiffs’ prior complaint, Judge Marrero found that the court lacked subject matter jurisdiction over the claims of non-U.S. resident plaintiffs who purchased their shares on non-U.S. exchanges. In granting the plaintiffs’ motion for leave to file an amended complaint, Judge Marrero reaffirmed that the court could not exercise jurisdiction over the claims of non-U.S. residents who purchased their shares on non-U.S. exchanges because the plaintiffs failed to allege sufficient U.S.-based conduct by the defendants. The court found, however, that the plaintiffs’ proposed second amended complaint alleged facts sufficient to allow the court to exercise jurisdiction over the claims of U.S. resident plaintiffs. Judge Marrero also found that the proposed second amended complaint sufficiently alleged securities fraud by the defendants. (“Previously Dismissed Credit Suisse Subprime Securities Suit Allowed to Proceed,” The D&O Diary, February 16, 2010; Cornwell, et al. v. Credit Suisse Group, et al, No. 08-Civ-3758 (S.D.N.Y. February 11, 2010))
Fraud and Ponzi Schemes
Stanford Employees Acquitted
On February 12, 2010, Bruce Perraud and Thomas Raffanello, two former employees of Stanford Financial Group, were acquitted in the U.S. District Court for the Southern District of Florida of charges that they conspired to shred thousands of documents at Stanford Financial’s Fort Lauderdale office six days after a federal court issued an order requiring the preservation of all business records. The court found that there was insufficient evidence to allow the case to proceed to a jury trial. Lawyers for Raffanello and Perraud argued that because all of the documents had been preserved electronically, Raffanello and Perraud had committed no crime. (“Update 1 – Stanford Financial Employees Acquitted,” Reuters, February 12, 2010)
Allen Stanford Seeks Dismissal of SEC Lawsuit
R. Allen Stanford recently filed a motion to dismiss a complaint filed by the Securities and Exchange Commission (SEC) in a Texas federal court, which alleges that Stanford operated a $7 billion Ponzi scheme. Stanford argues that the SEC’s complaint does not satisfy the minimum pleading requirements for a securities fraud claim. Lawyers for Stanford assert that the complaint does not allege “any specifics about what…Stanford said” or to whom he made fraudulent statements. Additionally, Stanford’s attorneys assert that the SEC does not have jurisdiction over the certificates of deposit issued by Stanford International Bank Ltd. because the certificates of deposit are not securities. In addition to the charges in the SEC complaint, Stanford faces federal criminal charges arising out of his alleged fraudulent scheme. (“Allen Stanford Asks Judge to Dismiss SEC Lawsuit Alleging Fraud,” Bloomberg.com, February 19, 2010)
Federal Prosecutors Expected to Ask for ‘Extraordinary’ Leniency for Top Madoff Aide
On February 19, 2010, a federal court in Manhattan made public court documents in which prosecutors expressed their intention to recommend “extraordinary” leniency for Frank DiPascali Jr., who has admitted to being Bernard Madoff’s top aide. DiPascali pleaded guilty to numerous charges relating to the massive Ponzi scheme, and is currently awaiting sentencing. According to prosecutors, DiPascali has “already provided substantial assistance to the government in its investigation and prosecution of others,” and “it is likely his cooperation will result in an extraordinary letter” in support of a lower sentence. At this time, it is unknown exactly what information DiPascali has given to the government to assist in its investigation and prosecution of other Madoff aides. Prosecutors argued against disclosing any such details, as disclosure would cause “significant harm” to the government’s criminal investigation into the Ponzi scheme. (“U.S. Strongly Favors Leniency for a Madoff Aide,” The New York Times, February 19, 2010)
Bankruptcy Judge Endorses Trustee’s Method of Calculating Madoff Losses
On March 1, 2010, federal bankruptcy Judge Burton R. Lifland endorsed the method used by the court-appointed trustee, Irving Picard, to calculate investor losses in Madoff’s massive Ponzi scheme. Picard has long argued that investor losses should be defined as the difference between the cash paid into a Madoff account and the amount withdrawn before the fraud collapsed in mid-December 2008. This method has been harshly criticized by many defrauded investors who seek to have their losses based on the balances shown on their final account statements provided just weeks before Madoff was arrested. Judge Lifland ended this dispute by endorsing Picard’s calculation method and finding that the final account statements “were bogus and reflected Madoff’s fantasy world of trading activity.” The court further found the statements cannot be the basis for determining a “security position” on which to establish claims and seek proceeds from the Securities Investor Protection Corporation, an industry-financed organization that provides limited protection for customers of failed Wall Street firms.
Picard has reported that true out-of-pocket cash losses for those that invested with Madoff may be about $20 billion. Although this represents an astonishing loss, Picard is far more likely to recover close to this amount in the Madoff liquidation process than he would if the judge had endorsed account statements as a basis for calculating loss. (“Madoff Judge Endorses Trustee’s Rule on Losses,” The New York Times, March 1, 2010)
Madoff Lawsuits Blocked by Luxembourg Court
On March 4, 2010, Luxembourg’s commercial court ruled that individuals who invested in funds linked to Madoff may not pursue claims against UBS and Ernst & Young. The court found that it was the responsibility of the liquidators of the funds that invested with Madoff to seek “recovery of the capital assets.” Investors lost millions through an Access International Advisors LLC fund called “LuxAlpha Sicav-American Selection.” LuxAlpha, which invested 95 percent of its assets with Madoff, later dissolved and is currently being liquidated. UBS served as custodian for LuxAlpha. Custodians are responsible for the oversight of funds and manage deposits and payments to investors. In December 2009, the liquidators for LuxAlpha filed a suit against UBS, Ernst & Young, Access International, and the Luxembourg regulator. In a statement, UBS said that it “welcomes the clarification of Luxembourg law as expressed by today’s decision.” Lawyers for the individual investors have vowed to appeal. (“UBS, Ernst & Young Win Bid to Block Madoff Lawsuits,” Bloomberg.com, March 4, 2010)
Prosecutors Seek 335-Year Sentence for the Petters Ponzi Scheme
In December 2009, Thomas Petters, founder of Petters Group Worldwide LLC, was found guilty by a federal jury in St. Paul, Minnesota, on 20 criminal counts, including wire fraud, mail fraud, and money laundering. Prosecutors accused Petters of running a $3.65 billion Ponzi scheme in which he used one of his companies to defraud investors who thought he was using their money to buy consumer electronics for resale to retailers such as BJ’s Wholesale Club Inc. and Costco Wholesale Corp.
In a sentencing memorandum filed on March 8, 2010, prosecutors urged the court to sentence Petters to 335 years for operating the Ponzi scheme. In support of their memorandum, prosecutors stated that, “[t]he defendant’s fraud is beyond comprehension” and that “[a] life sentence is wholly deserved and justified given the defendant’s corrupting influence on individuals and institutions, and his strident refusal to accept any responsibility.” Unlike Ponzi scheme mastermind Bernard Madoff, Petters did not plead guilty or acknowledge responsibility for operating the alleged fraudulent scheme. Attorneys for Petters have called the proposed sentence “unjustified” and have asked the court for leniency in light of Petters’ health condition and to impose a sentence not exceeding 12 years and seven months, similar to the sentence imposed on Walter Forbes, former chair of Cendant Corporation, who was also ordered to pay $3.3. billion after his conviction involving an accounting scandal. (“U.S. Seeks 335 Years for Ill Petters in Ponzi Case,” Reuters, March 9, 2010; “Petters Should Get 335 Years for $3.5 Billion Fraud, U.S. Says,” Bloomberg.com, March 9, 2010)
Government and Regulatory Intervention
Sen. Dodd Pushes Financial Regulatory Reform Forward
After months of negotiations between Democrats and Republicans in the Senate Banking Committee, the two sides have been unable to reach an agreement over financial regulatory reform. On March 11, 2010, Senate Banking Committee Chair Chris Dodd (D-Conn.) said that he will move forward with sweeping legislation to overhaul the current financial regulatory system. With bipartisan talks having failed to produce any legislation, Sen. Dodd is attempting to place pressure on those opposed to his plan by moving the debate into the open and pushing those against his proposed legislation to make their case publicly. To date, Democrats and Republicans have been unable to agree on the scope of powers any new consumer watchdog agency would have, as well as the scope of the Federal Reserve’s regulatory power over banks. Any legislation would need at least some support from both parties as Democrats control only 59 votes in the Senate, and 60 votes are needed to overcome a Republican filibuster. ("Financial Systems Reforms Won't Wait," The Washington Post, March 12, 2010)
Problem Banks Under Regulatory Scrutiny
According to a February 23, 2010 report issued by the Federal Deposit Insurance Corporation (FDIC), the number of banks on its “problem list” has reached 702, the highest number since June 1993. Nearly one out of every 11 banks is at risk of going under and is currently being closely scrutinized by the FDIC. With only 76 financial institutions on the problem list in the fourth quarter of 2007, it is clear that recession has pushed an increasingly high number of banks under the FDIC’s watch. Banks on the FDIC’s problem list are considered at a risk to fail because of difficulties with their finances, operations or management. Although the FDIC closely watches banks on its problem list, only 13 percent of banks on this list have been seized by regulators. Last year the FDIC seized a total of 140 lenders, and according to reports the agency may be on track to seize at least that many lenders this year, if not more. (“Banks at Risk of Going Bust Tops 700,” CNNMoney.com, February 23, 2010)
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