Mortgage Meltdown

In First Subprime Criminal Trial, Managers Of Bear Stearns Hedge Fund Acquitted

In the first criminal trial related to the subprime mortgage meltdown, prosecutors were unable to secure the convictions of Ralph Cioffi and Matthew Tannin when the jury acquitted each defendant on all counts today (coverage here and here).  Cioffi and Tannin were managers of two Bear Stearns hedge funds heavily invested in securities backed by subprime mortgages.  Those funds collapsed in mid-2007, and investors lost about $1.6 billion.  The two faced charges of wire fraud, securities fraud and conspiracy.  In addition, Cioffi was charged with insider trading.  He withdrew about $2 million of his own money from the hedge funds just prior to the collapse.

Based on coverage of the trial, it appears the prosecution had two major failings in the case.  First, the acquittal shows that a trial cannot be won on documents alone.  A trial is theater that requires real live witnesses to introduce the documents and tell the jury how the documents fit into the case.  Here, the government did not prepare this aspect of their case well enough.  For example, take the famous "toast" email.  On April 22, 2007, Mr. Tannin, in a message sent from his personal Gmail account to the personal account of Mr. Cioffi’s wife, wrote that “the whole subprime market is toast,” and if the CDO report "is ANYWHERE CLOSE to accurate I think we should close the funds now" and "There is simply no way for us to make money -- ever."   A few days later, on an investor conference call, Mr. Tannin assured investors:  "we're very comfortable exactly where we are" in the subprime market.

Pretty damning don't you think?  However, the prosecution failed to slam the door shut through the testimony of the author of the CDO report referenced in Tannin's email, and the defense, by all accounts (here, here, and here) was better able to use witness testimony to put the email into the context it wanted the jury to understand.  The defense brought out on cross-examination of the author that he was actually optimistic about the report, believing that the hedge funds could used increased volatility in the subprime market to make even more money.  By allowing this to come out on cross-examination rather than innoculating against it on direct, the prosecution allowed the author's state of mind (positive) to be reflected on to Tannin's state of mind (negative). 

Of course, it is Tannin's state of mind that was critical at the time he made the statements to investors.  If he believed that the hedge funds were in trouble at the time he made the positive statements to investors, he should have been convicted.  By failing to cement in the context on the "toast" email the prosecution allowed the defense to put its own context on the email and the case -- the future is uncertain, the defendants did not know where the subprime market was going, so they simply could not have had the intent to commit fraud.

The prosecution's case was also hurt by something that happened long before the case ever went to trial.  During the middle of the trial, the district judge prevented the prosecution from introducing another smoking gun email because it found the government's subpoena to get email from Tannin's Google email account violated the 4th Amendment (article here).   In the November 2006 email (again using a non-work account), Tannin wrote  “I became very worried very quickly....  Credit is only deteriorating. I was worried that this would all end badly and that I would have to look for work.”  Tannin went further stating the funds, under a more extreme situation could "blow up."  Another lesson for criminal and civil litigators alike.  Mistakes or carelessness in carrying out tasks early in the case can be compounded and magnified at trial.

In the end, the government's loss is significant for future prosecutions and may chill new criminal cases from being brought.  Given the climate amongst the general public following the financial crisis and the so-called Wall Street bailouts, one would have thought that juries would just be waiting to convict somebody, anybody, for the fallout everybody has felt from the subprime bubble bursting.  In the end, the defendants got a fair shake, and the defendants' lawyers apparently did a better job of putting the emails and other documents in context through the testimony of live witnesses.

Credit Crisis May Have Rendered Performance Of Contract Impossible Says 7th Circuit In Affirming Temporary Injunction

Last week the Seventh Circuit Court of Appeals affirmed (opinion here) a district court's decision to issue a temporary injunction preventing John Hancock Life Insurance from enforcing its contractual rights under a complicated sale/lease-back transaction with Hoosier Energy Rural Electric Cooperative.  In doing so, John Hancock was prevented from enforcing a surety bond from Ambac Insurance and the credit default swap Ambac obtained from Hoosier because Hoosier had the potentially viable defense that its own performance under the contract was commercially impossible because of the credit crisis.  Despite affirming the injunction, the court recognized the potential problems with excusing performance of a contract based on the credit crisis, and therefore expressed some skepticism about whether such an argument would ultimately be viable, and narrowly construed the application of the doctrine of commercial impracticality.

Case Background

Hoosier Energy, which is rural electrical cooperative, owns and operates a power plant in rural Indiana.  It entered into the sale/lease-back transaction with John Hancock, which was designed to allow John Hancock to reduce its income tax exposure.  Essentially, John Hancock purchased the power plant and then leased it back to Hoosier, taking the tax deductions for the depreciation on the property.  Since John Hancock was not in the business of running power plants, it had various protections in the contracts, including a credit default swap and a surety bond through Ambac.  As part of the deal, if Ambac's credit rating fell below a certain level, Hoosier had 60 days to find a replacement or John Hancock could force Ambac to pay on the bond. 

In turn, Hoosier would have to pay Ambac under the credit default swap.  This would have forced Hoosier into bankruptcy, and so the district court decided to issue the injunction, deciding this was irreparable harm.  In light of the irreperable harm, the district court held that "the credit crisis facing the world's economies in recent months is un-precedented" and that Hoosier showed a likelihood that it could not obtain a substitute surety at the height of the crisis at any price.  Thus, Hoosier's performance was excused under the doctrine of temporary commercial impracticality.

The Seventh Circuit's Decision

The Seventh Circuit held that  Hoosier could avoid the consequences of failing to find a replacement for Ambac if Hoosier can prove (1) that it had a contractual duty, rather than an option, to find a replacement for Ambac within the 60 day period, (2) that the 2008 credit crunch was unforeseeable to the parties at the time of contracting, and (3) that Hoosier really could not find any replacement for Ambac because of the credit crisis.  The court wrote, that, assuming a contractual duty rather than an option, "it might be possible to make out a real impossibility defense, meaning that (a) all parties to the transaction assumed, when they negotiated the terms, that it would be possible to find some other intermediary with adequate credit standing, and (b) as a result of a financial crisis, no such intermediary existed in late 2008, no matter how much Hoosier Energy offered to post in liquid assets to secure its obligations."

If the contract provision was simply an option -- Hoosier had the option of either finding a replacement surety for Ambac under the CDS or letting Ambac pay John Hancock -- then Hoosier's inability to find a replacement for Ambac to exercise its option would not excuse performance, the court said.  Using one of two football-related hypotheticals, the court noted that "Suppose that Hoosier Energy had an in-the-money option to purchase the Indianapolis Colts by the end of December 2008, and that as a result of the reduced availability of credit it was unable to find a lender to finance the transaction.  That would not make performance 'impossible' and extend the option's expiration, effectively giving Hoosier Energy a new option (for 2009) for free."  That is because the commercial impossiblity doctrine "never justifies failure to make a payment, because financial distress differs from impossiblity."

As a warning to other potential litigants that may want to seize on the commercial impossibility defense in light of the credit crisis and recession, the court noted "it is hard to see how an economic downturn can be alleviated by making contracts less reliable [because] [e]nforceable contracts are vital to economic productivity."  The court throughout the opinion attempted to limit the scope of the impossibility defense to prevent widespread use of the defense by financially troubled businesses attempting to get out from under bad contracts. 

It even took the somewhat unusual step of instructing the district court to vacate the injunction if Hoosier is unable to find a replacement for Ambac by the end of the year, noting that "what was impossible in fall 2008 may well be possible in fall 2009" and the "longer this impass continues, the more the balance of equities tilts in favor of John Hancock."  Given Ambac's credit rating had been downgraded twice during the pendency of the appeal and Hoosier, by its own argument, is financially troubled itself, the court reasoned that allowing the "temporary to drag out in the direction of permanence" would deprive John Hancock of the security it negotiated in the contracts.

Connecticut Judge Says UBS Probably Defrauded Hedge Fund In Sale Of CDO's

After a one-week hearing on a hedge fund's claim that UBS violated state securities laws when it sold mortgage-backed CDO's to it in 2007 and early 2008, a Connecticut trial court judge required UBS to post a $35 million bond to secure a potential future judgment against the investment bank.  In requiring the posting of a bond, the court found that there was "probable cause" for a determination that UBS had violated securities laws.

During the hearing, the court took testimony of several witnesses from UBS.  As quoted in the Reuters coverage of the decision (here), the court made several damning findings against UBS.  The main thrust of the decision is that UBS had already been told by rating agencies Moody's and S&P that they would be issuing downgrades on the credit ratings of the CDO's that UBS was selling.  Despite this knowledg, UBS sold the CDO's without disclosing the impending downgrades.

The main issue in this case is whether UBS had a duty to disclose the knowledge of impending downgrades.  The judge found that it did.  This is most likely based on the fact that the securities offering materials for the CDO's contained discussion of the risks of buying the securities, which no doubt included the risk or people defaulting on the mortgages that backed the CDO's.  The offering materials also no doubt touted the investment-grade rating of the bonds.  Under these circumstances, the court found that UBS had a duty to speak, to disclose the new information in order to correct the information already disclosed to investors.

The court also focused on internal UBS emails that referred to the CDO's it sold to the hedge fund as "crap" and "vomit" to support the allegations of fraudulent nondisclosure, and concluded that "UBS alone possessed the knowledge of what their product, their inventory, was truly worth.  While UBS would argue that such descriptors lack a precise meaning, the true meaning of these words and the true value of UBS's wares became abundantly clear when the Plaintiffs' multi-million dollar investment was completely wiped out and liquidated by UBS shortly after the last of the Note purchases was consummated."  Thus, in addition to the securities issues, this case is another example of how the careless use of email and the conversational tone that people use in emails can boomerang back at a company during litigation.

FDIC Gearing Up for Dead Bank Litigation?

So far this year, the FDIC has closed 57 banks (list here) at a cost of about $12.7 billion to the deposit insurance fund.  That is a lot of dead banks, and even more former bank directors and officers that may find themselves in the crosshairs of the FDIC in search of recovery for the billions of dollars it has paid out of the insurance fund -- that is, if there is a D&O insurance policy that could back up a judgment.

In an article at FinCriAdvisor, it was reported that the FDIC is sending out claim letters to managers of failed institutions in order to ferret out whether there may be insurance money available if the government were to bring a claim.  This is the first step in what could be a replay of the cases filed by the Resolution Trust Corporation in the wake of the last surge in financial institution failures - the savings and loan crisis.  And so it begins.

Catching Up

Well, it's good to be back writing this blog again.  Sorry to my readers for the long, unexplained absence.  I just returned from an almost month-long trial in Baltimore, Maryland (I am based in Reinhart's Milwaukee office).  A lot has happened in the interim, so let's get to it.  What follows is quick summary of some of the legal developments/stories from the mortgage meltdown:

(1)  Countrywide boss Anthony Mozilo was served with a "Wells notice" by the SEC.  As first reported by the Wall Street Journal and the L.A. Times, Countrywide's former CEO and other executives have been provided notice from the SEC that it intends to file formal civil charges for securities fraud and insider trading.  A Wells Notice is the name for this formal notification, and it provides the lawyers for Mozilo and the other executives to submit argument and evidence to try and persuade the Commission not to file the charges. Reuters June 2 story on the subject is here.  Although SEC may bring civil charges, criminal charges are also a possibility.

(2)  Subprime securities class action dismissal motions decided.  Several motions to dismiss were denied, as in the Moneygram, Inc. case involving allegations that the company failed to disclose risks of its own investments in mortgage backed securities (opinion here).  Similarly, a Florida District Court permitted claims to proceed against BankAtlantic Bankcorp., a Florida-based bank.  The court held that the amended complaint had cured prior deficiencies in pleading a strong inference of scienter (here).  Conversely, the case against Washington Mutual was dismissed with leave to amend (see here), and a securities fraud complaint against mortgage insurer Radian Group was dismissed with prejudice (here).  For more detail on these dismissals, go over to the D&O Diary blog which has consistent, in-depth analysis of the opinions and a running tally of the subprime securities motion to dismiss decisions.

(3)  Legislation Passed.  On May 20, President Obama signed two bills, the Helping Families Save Their Homes Act and the Fraud Enforcement and Recovery Act of 2009.  The first expands the mortgage foreclosure mitigation efforts, increased FDIC deposit insurance to $250,000 through 2013, and increases the borrowing authority for both the FDIC and the credit union deposit insurance counter-part.  The bankruptcy cramdown provision, which would have allowed bankruptcy judges to modify mortgages, was defeated and did not make it into the law.  The Fraud Enforcement and Recovery Act is intended to provide more resources and penalties for financial fraud, by extending the prohibition against making false statements in a mortgage application to employees and agents of a mortgage lending business; expanding the concept of monetary proceeds under federal anti-money laundering statutes to include gross receipts, a response to the Supreme Court’s June 2008 Santos decision; and expanding False Claims Act liability by, in part, overruling the Supreme Court's interpretation of the mental state required to prove a claim under the Act in Allison Engine Co. v. U.S. ex rel. Sanders, 128 S. Ct. 2123 (2008). 

(4)  More bank failures.  Throughout the first half of this year banks have failed at an accelerated rate, with the largest failure this year (the 34th) being Florida's BankUnited FSB, with $12.8 billion in assets.  The BankUnited closure was also notable because several private-equity firms, rather than another bank, purchased the deposits from the Office of Thrift Supervision and will operate the new BankUnited.  All of these bank closures have also substantially depleted the FDIC deposit insurance fund, so the FDIC approved a special assessment on banks to replenish the fund (the details are found here.)

(5)  Cleveland's Nuisance Suit Dismissed.  City of Cleveland's nuisance lawsuit against various investment banks and mortgage lenders was dismissed.  The district judge considering the case concluded that the nuisance claim was (1) barred by the economic loss doctrine, which prevents recovery in tort for purely economic damages (i.e. no personal injury or property damage); (2) preempted by Ohio law governing municipal regulations; (3) barred because a nuisance claim cannot be founded on subprime lending, which was lawful activity and heavily regulated; and (4) barred because the alleged damages were to remote.  The opinion is here. 

(6)  General Motors filed for bankruptcy protection this week at about the same time that another auto industry stalwart, Chrysler, was emerging from bankruptcy.  The United States government will own about 60% of the new GM.

New Century Financial Creditors Seek Over Billion Dollars From KPMG

In a what big four auditing firm KPMG would hope was just an April fools day prank, on April 1st a liquidating trust formed for the benefit of creditors in the New Century Financial bankruptcy has initiated a lawsuit against the company's auditor alleging damages in excess of $1 billion.  New Century was one of the largest subprime lenders, until it restated its financial statements in early 2007 which caused the flow of credit required to originate loans to dry up.  New Century filed for bankruptcy only a few months later, in April 2007.  The bankruptcy court appointed an examiner, who investigated the reasons for New Century's collapse.  The reportwas critical of KPMG's work.

KPMG is already a defendant in a securities class action lawsuit based largely on the bankruptcy examiner's report.  Now, New Century's creditors are taking a run at the auditors in two different lawsuits.  The first (here) was filed in California state court against KPMG LLP, the American audit partnership, that performed the audit work for New Century.  The second (here) was filed in federal court in New York against KPMG International, the parent entity of KPMG LLP.

Aside from any factual issues about the audit work, there are several interesting legal issues that should impact the case.  First, as the the California action, KPMG's agreement with New Century contained an arbitration clause.  The complaint alleges that the clause contains a prohibition on punitive damages, which are illegal under California law and which therefore invalidates the entire arbitration provision.  KPMG will certainly argue that even if the punitive damages clause in unenforceable, this should not invalidate the entire arbitration provision.  Next, the liquidating trust has asserted claims for aiding and abetting breaches of fiduciary duty by New Century management.  This claim may be barred by the legal doctrine of in pari delicto, which means that when two or more actors are at fault for the same damage one actor should not be able to sue the other.  Advisers to company's have successfully asserted this defense early on in similar litigation.  When a company's officers are alleged to have acted improperly, those actions typically get imputed to the corporation because it can only act through its managers.  Therefore, the argument provides that the liquidating trust, which stands in the shoes of the corporation, cannot sue an outside adviser for participating in the same wrong that the corporation knew about.  The argument has not been universally accepted, however.

The New York action is based on the legal theory that KPMG LLP is an agent of KPMG International.  It effectively seeks to pierce the corporate veil of KPMG International, which can be done under certain circumstances.  I think that the liquidating trust is fighting in uphill battle in this case.

New Litigation Round-Up

New cases arising from the ashes of the mortgage meltdown continue a-plenty and take many forms.  A sampling of recent cases:

ERISA  According to an article here, on January 29 the ERISA retirement plan for a Minneapolis glass-ware manufacturer called Apogee sued State Street Bank alleging that State Street breached its fiduciary duties to the plan.  State Street is alleged to have been an investment adviser to the fund.  According to the suit, State Street touted the Daily Bond Market Fund as a conservative, stable, risk-controlled, well-diversified option for Apogee's 401(k) plan, but changed the fund's strategy during 2006 to take on significantly more risk. Apogee alleged that State Street applied leverage in making the investments in subprime mortgage-backed securities, which had the effect of adding greater risk to the fund.  The fund also alleged that State Street prevented it from exiting the bond fund, while it allowed others to get out.  The fund alleges it lost $5 million.

Title Insurer Sued Over 1031 Exchange Program.  When the large title insurance company LandAmerica Financial Group, Inc. filed for bankruptcy last November, people who sold real estate in the months prior to the bankruptcy intending to reinvest the proceeds of the sale into new real estate through an IRS 1031 exchange (the benefit is deferring capital gains) had their money tied up in the bankruptcy.  For some it appears the money was tied up too long, and they lost their ability to make the exchange.  Several lawsuits have been filed against LandAmerica related to these issues, including a $300 million class-action lawsuit claiming breach of contract, fraud and theft of property filed in LandAmerica's bankruptcy case in Virginia.  A separate class action, raising similar issues, was filed in federal court in California.  As reported here, the cases are similar, and allege that the 1031 Exchange customers were misled about the financial health of LandAmerica.

Hedge Fund Sues Over Mortgage Bond Investments.  As reported by Bloomberg (here), Ellington Management Group LLC, the hedge-fund firm focused on mortgage bonds, sued Ameriquest Mortgage Co. and other ACC Capital Holdings units over soured subprime home loans.  Ellington alleges that its $354 million investment in certain bonds backed by subprime loans was virtually lost in its entiretly.  Ellington claims it was misled about the risk and the loans' potential for default.

Another Securities Class Action Filed.  This time the company in the cross-hairs is mortgage insurer Triad Guaranty, Inc.  The plaintiff's lawyers press release (here and here) from earlier today states that they allege that Triad misled investors about its underwriting practices for insuring Alt-A and pay-option mortgage and failed to adequately disclose to investors its weakening financial position as the financial crisis deepened throughout 2008. 

Tranche Warfare

Although securitized residential mortgages have been at the forefront of the credit crisis, commercial real estate debt has also been securitized, sliced, diced and sold to investors.  Some estimate that over $700 billion in commercial mortgage-backed securities are held by investors.  Now it seems a new front may be opening in the mortgage meltdown litigation - legal battles among holders of different tranches of securities backed by troubled commercial real estate.  What some have dubbed "tranche warfare."

Last week several outlets reported on the dispute among holders of various tranches of debt secured by the John Hancock Tower in Boston.  In 2006, a real estate investment firm called Broadway Real Estate Partners bought the building and a portfolio of other commercial real estate for $3.3 billion.  Back then, the Hancock Tower was valued at $1.3 billion.  Almost all of the purchase price was funded with debt.  There is a $650 million senior loan, and then about $450 million in a "mezzanine" loan that was split up amongh 9 investors.  This mezzanine debt was essentially a bridge loan which had to be paid within two years. 

In times of easy credit and soaring real estate values, it would have been easy for Broadway to refinance the debt at the end of the two-year period.  But now credit has become scarce, and in the sagging economy the Tower has gone from fully occupied to only 85% full, causing cash flow problems.  Thus, Broadway recently defaulted on a payment for the mezzanine loan.

That has touched off a battle among the holders of the various tranches of the mezzanine debt secured by the Tower.  Some estimate that the building is now worth only $700 to $900 million.  The terms of the mezzanine agreement provide that the most junior creditor still in the money (i.e. it would be paid off in a liquidation) based on an appraisal of the property would become the "controlling holder" and determine whether to foreclose on the mortgage.  The current skirmish is over which investor is "still in the money" should therefore be in control of decisions about foreclosure.

If the holders of the various tranches of the mezzanine funding cannot agree, one holder would likely file a foreclosure action and the other investors would then intervene to block the foreclosure or stay it pending a declaration from the court about who should be in charge.

To read more about the dispute, click here, here, and here.

Credit Crisis Excuses Contract Performance As Commercially Impractical

"This case provides a case study of some of the worst aspects of modern finance."  This is the opening line in Indiana Federal Judge David Hamilton's decision in Hoosier Energy Rural Electrical Cooperative, Inc. v. John Hancock Life Insurance Company, No. 08-CV-1560, 2008 WL 5068649 (S.D. Ind. Nov. 25, 2008).  The case involves a transaction described the judge as a "sham" and and abusive tax shelter, backed up by credit default swaps all revolving around the assets at a rural Indiana power plant.

SILO's and CDS

Hoosier Energy, which is rural electrical cooperative, owns and operates a power plant in rural Indiana.  In 2002, it appears that Hoosier was approached by John Hancock to enter into a "sale in - lease out" transaction (SILO) with John Hancock.  The transaction was specifically designed to allow John Hancock to claim to be the “owner” of the power plant for tax purposes and thus enable it to claim tens of millions of dollars of tax deductions (most likely due to depreciation of the equipment and plant facilities).  That deduction was useless to Hoosier because it was a non-profit energy cooperative.  Not surprisingly, the IRS has looked askance at these type of SILO transactions, finding them to be abusive tax shelters, although it has not gotten involved in the Hoosier - John Hancock deal.

The SILO transaction is complex (the transaction documents are over 4,000 pages) but essentially works as follows.  Under the transaction, Hoosier leased certain assets at the power plant to John Hancock for 63 years (longer than the useful lives of the assets) and John Hancock agreed to lease back the same assets to Hoosier for 30 years.  Hancock paid $300 million up-front for the lease rights.  Then John Hancock immediately leased the same assets back to Hoosier.  Hoosier pocketed about $20 million and deposited the remaining money with various entities of Ambac insurance company, which would disburse the funds back to John Hancock over time.

As part of the transaction, Hoosier was required to obtain a credit default swap (CDS) from Ambac to provide John Hancock with additional assurance that it would actually receive the lease payments.  Thus, if Hoosier defaulted on its payments, John Hancock was entitled to call in the swap and demand payment from Ambac.  Ambac, in turn, entered into a parallel CDS with Hoosier which would allow it to seek recovery from Hoosier for its payment to John Hancock.  As a further protection for John Hancock, the parties agreed that if Ambac's credit rating fell below AA, Hoosier would have 60 days to find another qualified swap provider or else John Hancock could declare Hoosier in default and demand immediate payment from Ambac under the CDS. 

Then in 2008, the credit crisis hit and Ambac's credit ratings, along with virtually every other financial guarantee company, were down-graded significantly -- below the AA rating required in the SILO agreements.  Hoosier attempted to find a replacement, but was unable to because of the credit crisis.  In late October, John Hancock sought to collect on the CDS. 

Hoosier Energy sought an injunction, claiming that it would be irreparably harmed because it would be forced into bankruptcy when Ambac sought to collect the payments it made to John Hancock from Hoosier.  Hoosier argued that the court would likely find later that the SILO transaction was an illegal sham transaction, and therefore unenforceable.  Hoosier also argued in the alternative that it was commercially impractical during the credit crisis to find a replacement for Ambac, and that it should therefore not be considered in default.

Commercial Impracticability

The court agreed with Hoosier on all points.  Of particular importance is the finding that Hoosier was likely to prevail on its commercial impracticality claim.  To relieve contract performance because of commercial impracticability, “the party must show that the un-foreseen event upon which excuse is predicated is due to factors beyond the party's control.”  Although the court noted that the doctrine should be applied with "great caution," he found that this could be one of those "extreme circumstances."  In so holding, the court wrote:

"If the nature and scope of the credit crisis were more limited or a mere economic downturn, John Han-cock's argument that the crisis was foreseeable or that Hoosier Energy should have protected itself better might be more persuasive. However, the credit crisis facing the world's economies in recent months is un-precedented and was not foretold by the world's pre-eminent economic experts. The crisis certainly was not anticipated in 2002, when the deal between Hoo-sier Energy, Ambac, and John Hancock was being finalized. Retrospect will not assist John Hancock here, nor will an assertion that it was Hoosier En-ergy's responsibility to prepare for and guard against any imaginable commercial calamity....

Hoosier Energy has come forward with evidence indicating that the obstacles it faced were not specific to Ambac but were the product of the credit crisis that effectively but temporarily froze the market for comparable credit products at any price.  Those effects were not anticipated and could not have been guarded against."

This is the first case I have seen endorsing the view that the credit crisis could excuse contract performance because the extreme and unforeseeable nature of the crisis would make performance under the contract commercially impractical.  It will be interesting to see if parties put forth similar defenses in other cases, and whether other courts will be receptive to those arguments.

Ambac Lawsuit Seeks To Recoup Losses From Mortgage Securitizer

Ambac Financial Group has recently filed a lawsuit against EMC Mortgage Corp. to recover over $130 million in insurance payments Ambac was forced to make when mortgage-backed securities issued by EMC failed. EMC is a former subsidiary of Bear Stearns, now owned by J.P. Morgan who acquired Bear Stearns when the venerable investment bank failed last year.

According to news reports (here and here), the complaint alleges that “entire pool of loans that EMC securitized in each transaction is plagued by rampant fraud and abdication of sound mortgage-origination and underwriting practices.” Ambac alleges that in one of the mortgage pools it found that 80% of the loans contained misrepresentations with respsect to borrower income, assets, and intentions to occupy purchased properties.

Ambac claims that EMC breached its contractual obligations by failing to repurchase or provide substitute loans so that the securities did not default and require Ambac to pay insurance claims. This could signal a new group of lawsuits in the subprime litigation wave which will determine who will bear the ultimate losses on these securitizations.