20 November 2007
Subprime mortgage lending practices and mortgage-backed securitizations are generating new types of litigation as company shareholders and others assert claims of reckless investment practices, material disclosure deficiencies, and fiduciary irresponsibility against corporations and their executives, practitioners told BNA in interviews.
Initially, litigation involving subprime mortgage loans was limited to borrowers and loan originators, the practitioners said.
But cases have recently been launched against securities firms, credit rating agencies, fiduciaries of retirement plans, and home builders, court records show. And lawyers involved with the cases said litigation involving subprime mortgage practices will not end anytime soon.
"The consumer-related claims and even the shareholder claims against the mortgage companies and loan originators were really the beginning, not the end, of the subprime crisis," Mayer Brown LLP partner Richard Spehr told BNA Nov. 5.
"And as the crisis continues, the claims will really be directed more at the other participants in the process, including investment banks and hedge funds and the like," he said.
The cases generally seek class certification and collectively seek billions of dollars in compensatory damages.
Securities Fraud Alleged
Several of the cases alleged companies and their senior executives violated the Securities Exchange Act of 1934 by misleading investors about the health of their firms.
Plaintiffs alleged the companies artificially inflated share prices by providing positive business assessments while failing to disclose facts the executives knew or should have known about exposure to potentially huge losses associated with subprime mortgages and their securitization, a review of the cases show.
Gerald Silk, a partner with Bernstein Litowitz Berger & Grossmann, who is involved in several of the cases, told BNA the claims will likely be further substantiated after reasonable opportunities for discovery.
Many of the cases claimed chief financial officers willingly signed and filed with the Securities and Exchange Commission Forms 10-Q stating their companies' financial statements did not contain any untrue or missing statements of material fact, the court filings said.
For example, in one U.S. District Court for the Eastern District of New York case, plaintiffs alleged that although a large publicly traded real estate investment trust (REIT) issued news releases and other statements reporting "highly successful" financial quarters and investor guidance projecting future company growth, in fact those and other statements "were materially false and misleading when made as they misrepresented the company's true condition, which included increasing levels of loan deficiencies" (Massung v. American Home Mortgage Investment Corp., E.D.N.Y., No. 2:07-cv-03350, filed 8/13/07).
The complaint documented the decline in American Home Mortgage intraday share prices, from $25.84 per share on April 9, 2007 to $19.55 one day later. In subsequent days, "Defendants continued to conceal the financial deterioration of the Company and its lack of liquidity," the complaint said. The complaint alleged the company's false and misleading statements violated two violations of the Exchange Act and harmed investors, and seeks compensatory damages and related expenses.
American Home Mortgage faces at least 11 securities fraud lawsuits, court records show.
Executives, Underwriters Named
Many of the lawsuits claiming securities fraud named chief executive officers as defendants; the complaints typically stated the executives knew public statements were false and misleading but made them anyway.
A suit against Calabasas, Calif.-based Countrywide Financial Corp, for example, claimed company chief executive officer Angelo Mozilo breached his fiduciary duties by failing to adequately disclose certain lending practices of his firm while he sold more than 12 million shares of Countrywide stock that generated proceeds in excess of $451 million (Arkansas Teacher Retirement System v. Mozilo, C.D. Cal., No. 07-cv-06923, filed 10/24/07). The complaint said the company's management allowed Countrywide insiders and a majority of the board "to unload shares before news of the Company's financial woes became known to its public investors."
Cases Filed Against Credit Rating Agencies
Meantime, lawsuits have been launched against two of the country's largest credit rating agencies, alleging the firms and their chief financial officers violated securities laws and fiduciary responsibilities by misrepresenting or failing to disclose the firms assigned "excessively high ratings" to securities backed by subprime mortgage loans.
Lawsuits were filed against the chief financial officer of New York-based The McGraw-Hill Companies (Reese v. Bahash, D. D.C., No. 1:07-cv-01530, filed 8/27/07), the parent company of Standard & Poor's, while a second case was filed against New York-based Moody's Corp. (Teamsters Local 282 Pension Trust Fund v. Moody's Corp. and Huber, S.D.N.Y., No. 07-cv-8375, filed 9/26/07).
Both complaints alleged the firms violated the Exchange Act of 1934 by making misleading statements in financial reports that ultimately led to a decline in company share prices, financial injuring shareholders.
"Defendants misrepresented or failed to disclose that the Company assigned excessively high ratings to bonds backed by risky subprime mortgages--including bonds packaged as collateralized debt obligations--which was materially misleading to investors concerning the quality and relative risk of these investments," the Moody's complaint said, assertions similar to those in the case against Standard & Poor's.
As McGraw-Hill's CFO, Bahash "was aware of, or recklessly disregarded, the misstatements contained [in shareholder and investor reports] therein and omissions therefrom, and was aware of their materially false and misleading nature," the McGraw-Hill complaint said.
Moody's Stock Price Cited
Information contained in some Moody's 2006 and 2007 quarterly financial statements "were materially false and misleading because Defendant misrepresented or failed to fully disclose that the Company assigned excessively high ratings to bonds back by risky subprime mortgages," the complaint said.
The complaint claimed Moody's engaged in a "fraudulent scheme" in part by issuing "materially misleading" financial information due to its role in rating securities whose underlying value was based on subprime mortgage loans.
"Disclosures of Moody's role in the rating and packaging of subprime loan securities caused Moody's stock price to decline below $45 per share in August 2007, after the stock had traded ... above $70 in June," the complaint said.
"As alleged herein, Defendants acted with scienter in that Defendants knew that the public documents and statements issued or disseminated in the name of the Company were materially false and misleading; knew that such statements or documents would be issued or disseminated to the investing public; and knowingly and substantially participated or acquiesced in the issuance or dissemination of such statements or documents as primary violations of the federal securities laws," the complaint said.
"We believe the complaint is without any factual or legal merit," McGraw Hill spokesman Frank Briamonte told BNA Oct. 31.
ERISA Violations Alleged
Another emerging type of case alleges violations of the Employee Retirement Income Security Act (ERISA). Launching these types of disputes is relatively new, with several filed since early October.
In one of the first cases to be filed, investors sought to reclaim losses incurred by a financial services company for alleged "reckless disregard of the best interests of investors in conservative bond funds," claiming the company invested in high-risk mortgage backed securities while telling investors it was placing their money in conservative, risk-adverse bond funds (Unisystems Inc. Employees Profit Sharing Plan v. State Street Bank and Trust Co., S.D.N.Y., No. 07-cv-9319, filed 10/17/07).
The financial services company, State Street Corp., breached its fiduciary responsibilities under ERISA "by causing State Street's purportedly conservative bond funds that are held in collective trusts ... to invest in high-risk and highly leveraged financial instruments tied to, among other things, mortgage backed securities," the complaint said.
Specifically, certain bond funds managed by State Street increased their holdings of mortgage-backed securities from 8.56 percent in September 2006 to 24.95 percent in March 2007, despite the fact that the indices those funds were supposed to track held about 60 percent government bonds and 40 percent corporate bonds, the complaint said.
"Had State Street managed the Bond Funds appropriately and according to their stated objective and risk level, the losses suffered by Plaintiff and the class of plans and persons they seek to represent would not have occurred," the complaint said. State Street describes itself as the world's leading provider of financial services to institutional investors, with $15.1 trillion in assets under custody and $2 trillion under management.
ERISA Fiduciary Named
In an ERISA case launched Nov. 5, defendants included not only a financial services firm, Citigroup Inc., but also its former chief executive officer Charles Prince; the company's "plans administrative committee," which administers the firm's retirement plans; and the 401(k) Investment Committee, which the complaint said is responsible for choosing plan investments and monitoring the performance of those funds (Gray v. Citigroup Inc., S.D.N.Y., No. 07-civ-9790, filed 11/5/07). The lawsuit also listed as defendants 20 John Does, which the complaint said are reserved for additional plan fiduciaries. ERISA requires qualified plans to name one or more plan fiduciaries.
The lawsuit seeks damages on behalf of the Citigroup 401(k) Plan and the Citibuilder 401(k) Plan for Puerto Rico operating and established by Citigroup as a benefit for its employees; Citigroup serves as "sponsor" of the plans, as defined by ERISA, the complaint said. The plans, which qualify as tax-advantaged "employee pension benefit" and "eligible individual account" plans within the meaning of ERISA, are not defendants in the case, but pursuant to ERISA language the relief requested is for the benefit of the plans.
Citigroup and some of its senior managers "allowed the imprudent investment of the Plans' assets in Citigroup common stock through the Class Period despite the fact that they clearly knew or should have known that such investment was unduly risky and imprudent due to the Company's serious mismanagement and improper business practices," the complaint said.
"In particular, Plaintiff alleges that Defendants breached their fiduciary duties to the participants of the Plans because they knew or should have known that the Company's securities were no longer a prudent investment, yet they failed to take steps to eliminate or reduce the amount of Company stock in the Plans, and failed to give Plaintiff and the Class complete and accurate information about Citigroup's loan loss exposure so they could make informed investment choices under the Plans," the complaint said.
Based on publicly available information, losses to the plans total $1.3 billion as of Nov. 5, the complaint said.
Other ERISA cases filed recently include a case in U.S. District Court for the Central District of California (Chatman v. Countrywide Financial Corp., C.D. Calif., No. 2:07-cv-06695, filed 10/16/07), which made similar allegations to those in the State Street case.
Are Investment Banks Exposed?
Investment banks also are being eyed by plaintiffs and their attorneys. A complaint filed in the U.S. District Court for the Southern District of New York by institutional investors listed several investment banks as defendants, including Bear Stearns & Co. Inc., Deutsche Banc Securities Inc., Piper Jaffray & Co., and Roth Capital Partners LLC (The Jay Peter Kaufman Revocable Trust v. New Century Financial Corp., C.D. Cal, No. 8:07-cv-00585, filed 5/22/07).
Underwriters in the lawsuit are liable due to information contained in prospectuses and other offering documents, the complaint said.
According to Silk, the untrue and misleading statements allegedly appeared in offering documents and prospectuses.
Kreindler & Kreindler LLP partner Mark Labaton told BNA many of the securities fraud cases will likely be consolidated instead of allowing several suits alleging the same types of violations to be argued within the same jurisdiction.
Five Types of Cases Seen
Mayer Brown's Spehr, a securities litigator for more than 20 years who is currently advising clients on subprime mortgage lending issues, said potential cases involving investment banks may be classified into five types of cases.
The first type is a class action claiming securities fraud by the investment bank's shareholders. In such a case, the class would claim the bank did not properly disclose its exposure to risky subprime mortgage assets, and that class members were harmed when the bank's stock price declined after public disclosures revealed the exposure, he said.
An example of this type of case is a federal district court case in which shareholders alleged Merrill Lynch LLP failed to disclose adequately the extent of its exposure to subprime investments (Life Enrichment Foundation v. Merrill Lynch & Co., S.D. N.Y., No. 1:07-cv-09633, filed 10/30/07). "So far as I know, that is the first such suit brought against any of the [large investment] banks, but it will not be the last," Spehr said.
Second, investment banks that securitized pools of subprime mortgages and then sold the securities to investors may face lawsuits claiming the banks failed to disclose adequately in their prospectuses risks associated with the securitizations and failed to correct any alleged initial error by properly disclosing any changes in risk once the securities were sold, he said.
Third, investment banks may face claims they aided and abetted fraud committed by hedge funds, Spehr said. In one current case, a hedge fund collapsed amid claims it overvalued its portfolios (Securities & Exchange Commission v. Beacon Hill Asset Management LLC, S.D.N.Y., No. 02-cv-8855, filed 6/14/04).
In that case, the brokerage units of two major banks and a major accounting firm were alleged to have collaborated with Beacon Hill in improperly valuing securities held by the hedge funds.
The case, which was filed in 2004, is apparently still open. The most recent docket entry, which was dated Nov. 8, 2007, sought a change in interest rate in connection with assets held by Beacon Hill Master, Ltd.
Fourth, investment banks and brokers may face lawsuits from customers claiming those institutions invested their funds in vehicles heavily exposed to securities whose underlying value was based on subprime mortgages without disclosing to the customers how risky that investment strategy might be, Spehr said.
And fifth, Spehr said investment banks may face legal actions from trustees of now defunct loan originators claiming the banks in the securitization process somehow aided and abetted the misconduct of the management of the bankrupt originator. In one such case, American Business Financial Services's trustee claimed that five major banks participating in the securitization process aided and abetted the misconduct of the management of the bankrupt originator to the detriment of the originator's creditors (Miller v. Santilli, E.D. Pa., No. 06-cv-3587, filed 9/20/06).
Several Defenses Possible
Spehr said existing cases and some yet to be decided may offer strong defenses.
Much could depend on a case recently argued before the U.S. Supreme Court (Stoneridge Investment Partners LLC v. Scientific-Atlanta Inc., U.S., No. 06-43, argued 10/9/07).
Stoneridge, which was argued Oct. 9 (209 DER A-21, 10/30/07), focuses on whether 1934 Securities Exchange Act Section 10(b) antifraud proscriptions afford a private remedy against vendors that allegedly help a company inflate its reported financials, but that did not themselves make material misstatements. In Stoneridge, the court is considering whether an allegation of "scheme liability" can circumvent an earlier ruling prohibiting aiding and abetting claims in federal securities suits.
He said other defenses based on U.S. Supreme Court cases include:
- Twombly v. Bell Atlantic Corp. (U.S., No. 05-1126) in which the plaintiff must plead facts "plausibly suggesting," and not merely consistent with, the violation alleged;
- Tellabs Inc. v. Makor Issues & Rights Ltd. (U.S., No. 06-484) which held plaintiffs pleading facts raising a strong inference of scienter must be more than merely plausible or reasonable; and
- Dura Pharmaceuticals, Inc. v. Broudo (U.S., No. 03-932) a case that successfully argued that an allegedly artificially inflated share price is not adequate to demonstrate financial loss due to fraud.
Home Builders Targeted
Subprime-related lawsuits against home builders have also been launched in which classes of shareholders allege that builders engaged in fraudulent behavior.
In one case, Horsham, Pa.-based Toll Brothers Inc. faces securities claims by shareholders who said the firm made false and misleading statements about the firm's business plan of building relatively expensive homes, which the company fraudulently claimed was "unique and thus immune from the adverse impact of rising interest rates and other negative macro-economic factors" (Lowrey v. Toll Brothers, E.Pa., No. 07-cv-1513, filed 4/17/07).
Another case against a home builder alleges different legal violations. In a North Carolina Superior Court case, plaintiffs alleged a home builder conspired with affiliated mortgage industry participants to engage in a "pattern of deceit and misrepresentation regarding home sales and mortgage applications" and affirmatively concealed material facts (Coleman v. Beazer Homes Corp., N.C. Super.Ct., No. 07-cv-13085, filed 6/3/07). Specifically, the complaint alleged that the plaintiffs, "who are inexperienced, unsophisticated real estate consumers," were coerced into purchasing homes built and financed by Beazer in a North Carolina subdivision that is now heavily scarred by foreclosures.
Beazer and an affiliated mortgage company violated their fiduciary duties by not acting with reasonable skill, care, and diligence in its lending practices and did not make efforts to secure loans that were "reasonably advantageous to the circumstances, including the rates, charges, and repayment terms," the complaint said.'
The Beazer complaint further alleged the defendants engaged in practices not in good faith or fair dealing, including failing to disclose material terms from borrowers, failing to give due regard toward borrowers' short and long-term repayment abilities, and placing borrowers in loans which they could not reasonably be expected to afford.
By Stephen Joyce