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Publications
Subprime/Credit Crunch Digest (Part I)
September 2008
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, litigation and regulatory actions arising from the subprime mortgage crisis and credit crunch.
This month’s issue focuses on recent actions concerning litigation – such as a bankruptcy judge’s rejection of a proffered Countrywide settlement – and SEC investigations, regulatory reforms in the works, the Freddie Mac/Fannie Mae takeover, and the aftermath of auction rate securities fiascos.
Litigation and Regulatory Investigations
Countrywide Settlement Rejected by Bankruptcy Judge
Countrywide Financial Corporation, which was acquired by Bank of America last month, recently offered to settle a lawsuit filed by 300 borrowers alleging that the company employed abusive practices by making inaccurate claims, filing unnecessary court papers and charging improper fees. Countrywide offered to pay the bankruptcy trustee $325,000 to cover litigation costs and to settle 293 actions. On August 14, 2008, U.S. Bankruptcy Court Judge Thomas P. Agresi issued an order rejecting the settlement. Judge Agresi stated that the settlement was unfair to borrowers who were allegedly hurt by the company’s abusive practices, and that Countrywide and the trustee seemed to be merely “agreeing to agree” with regard to helping borrowers. In addition, Judge Agresi indicated that one-third of any settlement payment should go to the borrowers’ attorneys, instead of paying the entire amount to the trustee. Countrywide and the trustee were instructed to address these concerns regarding the proposed settlement. A status conference has been set for October 2, 2008. (“Judge Rejects Countrywide Settlement,” The New York Times, August 16, 2008)
SEC Launches Informal Probe Into National City
The U.S. Securities and Exchange Commission (SEC) announced on August 8, 2008, that it has requested documents from National City Corp. as part of an “informal probe” into the sale of its former subprime mortgage unit, First Franklin Financial Corp. The SEC reportedly requested documents concerning the bank’s loan underwriting practices, dividends and bank regulatory matters. In response, National City stated that the SEC has not alleged that it acted improperly or illegally. (“SEC Requests Documents from National City,” The Associated Press, August 8, 2008)
Government and Regulatory Intervention
Regulatory Reforms Expected for Financial Institutions in 2009
Major reform is reportedly on the horizon for U.S. financial institutions as efforts to overhaul banking regulations are gathering pace. Such efforts are likely to intensify as a new Congress and administration take office early next year. Commentators note that there is a push to safeguard public money that has been put at risk by recent rescue measures by government agencies such as the U.S. Treasury and Federal Reserve Bank. The new administration will likely seek reform to distance itself from the current regime and the credit market crisis. (“A Sarbox For Banks? It Could,” FinancialWeek.com, August 25, 2008)
U.S. Takes Over Freddie Mac and Fannie Mae
U.S. Treasury Secretary Henry Paulson announced plans on September 7, 2008, to seize mortgage giants Federal Home Loan Mortgage Corporation (Freddie Mac) and Federal National Mortgage Association (Fannie Mae) and replace the companies’ chief executive officers. The plan will create a conservatorship that gives management control to the Federal Housing Finance Agency, the agency that regulates the companies. The intervention marks the failure of the public-private experiment created to boost home ownership among Americans. Paulson indicated that he plans to remake the U.S. housing finance system by eliminating government-sponsored enterprises such as Fannie Mae and Freddie Mac. The plan calls for the Treasury to acquire $1 billion of preferred shares in each company without providing immediate cash, and to pledge as much as $200 billion as the companies deal with significant losses due to mortgage defaults. More than $5 trillion of debt and mortgage-backed securities issued by Freddie Mac and Fannie Mae is owned by central banks and investors worldwide. The intervention may cost taxpayers billions in losses from home loans made by the private sector. The rescue is also likely to lead to billions in losses for stockholders. (“U.S. Seizes Mortgage Giants,” The Wall Street Journal, September 8, 2008)
Auction Rate Securities
NYAG Expected to File ARS Litigation Against Citigroup
In early August, New York Attorney General (NYAG) Andrew Cuomo announced plans to take legal action against Citigroup in connection with its sale of auction rate securities (ARS). Cuomo alleges that Citigroup knowingly misled investors about the risks associated with ARS and destroyed evidence that his office requested as part of its investigation into the sales practices of several Wall Street banks. According to reports, the destroyed evidence included a series of taped conversations among Citigroup employees. Cuomo reportedly intends to pursue claims against the company under New York State’s Martin Act, which allows him to bring both civil and criminal charges. Citigroup maintains that it “has acted in good faith and in the best interests of our clients … and there is no basis for claims to the contrary." (“Citigroup faces suit on misleading its clients,” International Herald Tribune, August 4, 2008)
UBS General Counsel Resigns in Wake of ARS Investigation
UBS announced on August 4, 2008, the resignation of David Aufhauser, general counsel for its investment bank division and American operations. According to reports, Aufhauser was at the center of the NYAG’s investigation into UBS’ ARS practices. NYAG Andrew Cuomo is investigating UBS and its sale of ARS as part of a larger probe into how Wall Street handled these securities. Cuomo has filed a lawsuit against UBS alleging that it committed fraud by misleading investors regarding the risk of investments in ARS. The lawsuit alleges, among other things, that insiders at UBS sold their ARS holdings while the company continued to market ARS to clients. (“UBS Executive Resigns Amid New York State Investigation,” The New York Times, August 5, 2008)
Stifel Financial Corp. Faces Securities Class Action Over Auction Rate Securities
In early August, a purported securities class action lawsuit was filed against Stifel Financial Corporation alleging that the company and its subsidiary violated federal securities laws by deceiving investors about ARS, as well as the market in which those securities are traded. The suit generally contends that investors in ARS sold by Stifel were unable to liquidate their investments after Stifel and other major broker-dealers withdrew their support for the auctions in which those securities were involved. In addition, the plaintiffs allege that the ARS were marketed as “highly liquid” investments and as “suitable alternatives to money market mutual funds.” (“Merrick v. Stifel Financial Corp., et al,” Stanford Law School Securities Class Action Clearinghouse, August 8, 2008)
Morgan Stanley and JP Morgan Settle ARS Claims by NYAG
NYAG Andrew Cuomo announced on August 14, 2008, that his office had reached settlements with Morgan Stanley and J.P. Morgan under which the firms agreed to buy back billions in ARS debt and pay fines to resolve claims that they misled investors regarding the risks associated with ARS. Under the agreement, Morgan Stanley agreed to repurchase $4.5 billion of debt from retail customers, charities and small to midsized businesses and to pay a $35 million fine to the state. J.P. Morgan agreed to buy back $3 billion in debt and to pay a $25 million fine, and indicated that the buyback will result in a $400 million pretax charge. The NYAG generally alleged that the firms misled investors about the risk of investment in ARS. (“Morgan Stanley, J.P. Morgan Reach ARS Settlement Agreements,” FinancialWeek.com, August 14, 2008)
Merrill Lynch and Wachovia Settle to Avoid ARS Litigation
Several states have commenced investigations into other brokers that sold ARS to clients. In an effort to avoid litigation, Merrill Lynch and Wachovia have offered to buy back approximately $12 million and $9.5 million worth of ARS, respectively. In addition, Wachovia has agreed to pay $50 million in fines to be distributed among several states. (“Wachovia to Buy Back Auction-Rate Securities; Merrill Faces Suit,” USA Today, August 15, 2008)
NYAG Intensifies ARS Probe
The NYAG announced plans August 20, 2008, to target Bank of America Corp., Goldman Sachs and Deutsche Bank AG in his industrywide investigation of ARS sales. His office reportedly has uncovered “disturbing facts” as part of the investigation. For example, Cuomo has indicated that Fidelity, the world’s largest mutual fund, actively marketed ARS to clients and allegedly offered financial incentives to representatives that sold these securities. The NYAG also contends that brokerages “deliberately stuck their heads in the sand” as they continued to market ARS and to mislead investors. UBS, Morgan Stanley, J.P. Morgan, Wachovia and Citigroup are among the banks that have agreed to buy back billions worth of ARS debt as a result of NYAG’s industrywide investigation. (“New York AG intensifies auction-rate debt probe,” Reuters, August 20, 2008)
FINRA Investigates Auction Rate Securities
In an effort to enforce the rules of the Financial Industry Regulatory Authority (FINRA), which operates under the oversight of the SEC, government agents are scheduled to review the ARS operations of about 40 firms throughout late August and early September. The investigation reportedly will focus on the period of June 1, 2007 to June 30, 2008. Although the investigators do not have subpoena power, they plan to undertake on-site reviews of firms with large amounts of ARS. Investigators are asking firms to identify ARS issues, auction failures and employees on their ARS desks. In addition, the investigation seeks to identify individuals responsible for determining when the firms would place bids. FINRA also has requested that the firms produce internal and external correspondence and marketing materials pertaining to ARS, the dollar amount of ARS held in their accounts and complaint records from clients. The firms targeted by the investigation have not yet been identified. (“Financial Agency Probes Firms Over Auction-Rates,” Reuters, August 21, 2008)
Citigroup Faces ARS Class Action Lawsuit
Investors who purchased ARS underwritten or sold in auctions managed by Citigroup filed a purported securities class action on August 25, 2008, against Citigroup and its affiliates. The lawsuit generally alleges that from August 1, 2007 through February 11, 2008, Citigroup manipulated the ARS market by misrepresenting the existence of a valid market for the securities. The plaintiffs allege that Citigroup routinely and regularly intervened to ensure that its auctions did not fail. It is also alleged that when Citigroup ceased intervening, the auctions failed and investors were left with billions of dollars of ARS and no market to sell the securities. (“Zwerling, Schachter & Zwerling, LLP, On Behalf Of Lead Plaintiff, Files Consolidated Amended Complaint In 'In Re Citigroup Auction Rate Securities Litigation,” MarketWatch.com, August 26, 2008)
BOA Agrees to Repurchase Securities from Massachusetts Agencies
Massachusetts securities regulators recently announced that Bank of America (BOA) agreed to buy back $43 million in ARS from various state agencies, including $18 million from the Massachusetts Turnpike Authority and $25 million from the Massachusetts Housing Partnership. According to the secretary of the commonwealth, the agreement is not a settlement. The securities division plans to continue negotiations with BOA in an effort to have it repurchase all ARS from retail investors within the state. (“BofA to Buy Securities Back From State,” The Wall Street Journal, August 28, 2008)
Ex-Credit Suisse Brokers Indicted for Fraud
On September 3, 2008, former Credit Suisse brokers Eric Butler and Julian Tzolov were charged with fraud and conspiracy in connection with deceptive sales of ARS. Butler pleaded not guilty to charges of conspiracy, securities fraud and wire fraud. Tzolov is believed to be out of the country. The former brokers are accused of misleading clients into believing that ARS purchased for customers were backed by federal guaranteed student loans. In a separate complaint, the SEC accuses the men of having purchased more than $1 billion in ARS collateralized by subprime mortgages and other non-federally guaranteed non-student loan collateral, for corporate clients without their authorization. Credit Suisse responded to the charges stating that the former brokers resigned once Credit Suisse detected their prohibited activity and suspended them. Financial industry regulators have been investigating firms throughout the country since the market froze in February 2008 as part of an industrywide probe of ARS. (“Ex-Credit Suisse Brokers Accused of Fraud Scheme,” Reuters, September 3, 2008)
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