Corporate America, brace yourself: The unending fallout of the global financial crisis continues to drive a wide range of complicated and highly aggressive securities litigation. Worse yet, filing activity shows no signs of slowing down.
According to a recent report by NERA Economic Consulting, litigation related to the credit crisis-related skyrocketed from 69 cases in 2007 to 188 cases in 2008, a jump of 172 percent. Another 46 such cases were filed in the first quarter of 2009 alone.
Those numbers are “only to be expected given the market dislocations we’ve had over the last 18 months or so,” says Steven Scholes of law firm McDermott Will & Emery. Disputes over structured financial products, such as collateralized debt obligations and collateralized mortgage obligations, are leading the way. “We’ve had a tremendous amount of litigation in that area,” he says.
Scholes
Litigation over credit default swaps is also rising, with “a significant likelihood there will be more,” Scholes says. Data from the NERA report backs that claim: lawsuits over collateralized debt obligations and credit default swaps made up 3 percent of securities litigation in 2007, and a whopping 22 percent in 2008. Much CDO-related litigation stems from allegations of failure to disclose the underlying collateral of the CDO and misrepresentations of its quality, notes Faten Sabry, vice president of NERA Economic Consulting’s securities and finance practice.
The nature of the cases has also changed. During late 2006 and most of 2007, the majority of credit crisis-related suits were filed against lenders, originators, and homebuilders. Since 2008, however, as the credit crisis has grown more severe, an increasing number of the suits have targeted asset management firms, Sabry says.
That can be attributed to the “unprecedented size, scope, and number of the alleged Ponzi schemes, which seem to be coming to light as a result of the decline in asset values,” Scholes says. “I think that wave is still building and has yet to crest.”
FILINGS INCREASE
From January 2007 to March 17, 2009, NERA recorded 303 credit crisis filings. The chart below presents the number of credit crisis filings by quarter.
Quarter
2007
2008
2009*
1Q
6
45
46
2Q
7
52
3Q
17
43
4Q
39
48
* Q1 only through March 17, 2009.
Source: NERA Economic Consulting.
Experts are also closely watching the number of securities cases related to bankruptcy filings. “I think that is going to be an interesting area of the law going forward, as it seems more and more companies are seeking bankruptcy protection,” says Patricia Connally of the law firm Crowell & Moring.
“Typically, we’ve seen a remarkable amount of that lately,” says Scholes. “That is usually a breeding ground for securities-related litigation.”
Sabry
Sabry cites the case against commercial real estate company General Growth Properties—the second largest owner of shopping malls in the United States—as an example. The case is being watched by the financial industry because of General Growth’s unusual move to sweep 166 of its supposedly “bankruptcy remote” malls, which had been set up as special purpose entities, into its overall bankruptcy. Now the malls’ debt holders are crying foul. A ruling is expected on the case before the end of the month.
D&O Insurance
Directors and officers continue to remain prime targets in credit-crisis litigation, Sabry says. In 2008, 62 percent of cases named individual directors and officers as defendants; that has risen to 72 percent so far this year.
“Based on that report, directors and officers are clearly in the line of fire,” says Connally.
CDO CASES
In general, the CDO-related cases allege failures to disclose proper valuations and misrepresentations about the quality of the underlying collateral. NERA discusses the following three cases in more detail.
Bank of America, National Association, and Banc of America Securities v. Bear Stearns Asset Management et al.
Bank of America filed a suit against Bear Stearns Asset Management that focuses on a $4 billion CDO that Bank of America structured and marketed. The CDO collateral included mortgage-backed assets which were primarily owned by two Bear Stearns hedge funds. The lawsuit alleges that Bear Stearns Asset Management:
“ … concealed from Bank of America (as well as from the two hedge funds’ investors and other creditors) that the hedge funds were suffering substantial withdrawal requests from investors and by the spring of 2007 were in imminent danger of collapse. The eventual collapse of the funds in June 2007—an event that contributed to the ultimate demise of Bear Stearns—predictably caused an enormous decline in the value of both the assets underlying the CDO-squared transaction and the securities issued in the transaction. As a direct and foreseeable consequence of Defendants’ misconduct, the Bank sustained significant losses. ”
Southeastern Pennsylvania Transportation Authority et al. v. Lehman Brothers Holdings et al.
In another CDO-related lawsuit, shareholders filed a class action against Lehman Brothers. The suit alleges violations of Rule 10b-5 and Section 20(a) due to, among other factors, Lehman Brothers’ alleged misrepresentation and failure to disclose the proper value of its CDO portfolio. The complaint claims:
“ … (1) that the Company had failed to fully disclose the nature and extent of its exposure to losses incurred from trading in subprime mortgage backed derivatives; (2) that the Company had failed to fully disclose the nature and extent of its exposure to losses incurred from CDOs, and had failed to timely write-down its positions in these securities; (3) that the Company had failed to fully disclose the nature and extent of its exposure to losses incurred from mortgage backed security originations, and had failed to timely write-down its positions in these securities; (4) that the Company had materially overvalued its positions in commercial and subprime mortgages, and in securities tied to these mortgages; (5) that the Company had inadequate reserves for its mortgage and credit related exposure; (6) that the Company’s financial statements were not prepared in accordance with Generally Accepted Accounting Principles (“GAAP”); and (7) that the Company lacked adequate internal and financial controls. ”
Harold H. Powell Trust et al. v. Royal Bank of Scotland Group et al.
A recent class action brought against the Royal Bank of Scotland involves purchasers of the RBS Preferred Series T Stock, which was issued in September 2007. The complaint alleges that “ … RBS was suffering from several adverse factors that were not revealed.” These factors included, “ … extensive investments in asset backed securities, including collateralized debt obligations (CDOs), and its exposure to the subprime mortgage market. ” The complaint alleges that RBS failed to adequately write down bad assets and was forced to “face the long term consequences of its short term focus” after the housing bubble burst.
Source
NERA Economic Consulting (June 15, 2009).
The now-notorious securities fraud case, In re: HealthSouth Corp. Securities Litigation is one such example. In that case, HealthSouth reached a $445 million partial settlement with its investors in 2006, stemming from allegations that the company overstated corporate revenues by $2.7 billion from 1996 to 2002.
But former CEO Richard Scrushy—who was acquitted on criminal charges related to the fraud, but is serving a prison sentence anyway for bribing a former governor of Alabama—sued to block that settlement, saying it improperly terminated his right as a corporate officer to have HealthSouth cover his legal fees and any part of the settlement he might owe. On June 18, however, a federal appeals court ruled against him.
Connally
As the number of claims against directors and officers rise, companies are seeking higher coverage limits on their D&O policies, Connally says. As a tradeoff to get those increased limits, companies are also swallowing higher deductibles, “meaning they’re retaining more of the risk than they have in the past,” she says.
How such cases against directors and officers play out—whether it be through regulatory agencies, SEC investigations, or shareholder derivative lawsuits—“will certainly have a direct impact on the pricing and the types of D&O policies being issued by companies,” Connally says. Indeed, the cost of D&O insurance in the financial sector is soaring, she says. “We started seeing that in late 2008 and that seems to be continuing into 2009.”
High Court Weighs In
Some important securities-related cases are also expected to make their way to the U.S. Supreme Court. One particularly murky issue: when the statue of limitations of a federal securities fraud claim is triggered.
The most recent lawsuit, In re Merck, stems from allegations that pharmaceutical giant Merck mislead shareholders by downplaying the heart-attack risks linked to its painkiller Vioxx. But a federal judge dismissed the case after finding that the lawsuit, which had been filed in 2003, fell outside the two-year statute of limitations. The judge said that the plaintiffs should have known about the alleged fraud in 2001, when a report containing damaging data about Merck was released.
Now it’s up to the Supreme Court to decide when the statute of limitations is triggered. The High Court last addressed the issue nearly 20 years ago.
Another notable issue that the Supreme Court may take up this fall is whether foreign investors who purchased shares of a foreign company on a foreign stock exchange can still sue the company in U.S. courts.
The Second Circuit Court of Appeals ruled on such “F-cubed” lawsuits for the first time ever in October 2008, in Morrison v. National Australia Bank, deciding that the suit was beyond the jurisdiction of U.S. courts. The plaintiffs claimed U.S. jurisdiction because a small U.S. subsidiary had faulty accounting results that were incorporated in the parent’s statements, causing National Australia to report false financials. Now, unhappy Australian investors are pleading to the Supreme Court to hear the case.
Scholes says the ruling is significant because it leaves open the possibility that jurisdiction could exist under different circumstances, “where perhaps 10 years ago you wouldn’t have seen the jurisdiction of U.S. courts being put to the test,” he says. “And that may well open up a fairly rich vein of cases for plaintiffs’ lawyers.”
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