Mortgage Meltdown

9th Circuit Affirms Dismissal of Fraud Claims Against MERS And Banks

Yesterday, the Ninth Circuit Court of Appeals affirmed dismissal (opinion here) of a fraud lawsuit against the large mortgage lenders that banded together to form the Mortgage Electronic Registration System.  Mortgage loan giants Fannie Mae and Freddie Mac and several of the largest U.S. banks established MERS in 1995 to circumvent the costly and cumbersome process of transferring ownership of mortgages and recording the changes with county clerks.

Among other claims, the plaintiff class alleged that the mortgage lenders conspired to commit fraud in forming MERS.  The alleged that "MERS members conspired to commit fraud by using MERS as a sham beneficiary, promoting and facilitating predatory lending practices through the use of MERS, and making it impossible for borrowers or regulators to track the changes in lenders."

The court concluded that the claims were not plausible, and so affirmed the district court's dismissal of them.  Aside from finding the allegations inadequate, the court also relied on the language included in the standard mortgage/deed issued as part of a MERS transaction:

"While the plaintiffs’ allegations alone fail to raise a plausible fraud claim, we also note that their claim is undercut by the terms in Cervantes’s standard deed of trust, which describe MERS’s role in the home loan.2 For example, the plaintiffs allege they were defrauded because MERS is a “sham” beneficiary without a financial interest in the loan, yet the disclosures in the deed indicate that MERS is acting “solely as a nominee for Lender and Lender’s successors and assigns” and holds “only legal title to the interest granted by Borrower in this Security Instrument.” Further, while the plaintiffs indicate that MERS was used to hide who owned the loan, the deed states that the loan or a partial interest in it “can be sold one or more times without prior notice to Borrower,” but that “[i]f there is a change in Loan Servicer, Borrower will be given written notice of the change” as required by consumer protection laws. Finally, the deed indicates that MERS has “the right to foreclose and sell the property.” By signing the deeds of trust, the plaintiffs agreed to the terms and were on notice of the contents. See Kenly v. Miracle Props., 412 F. Supp. 1072, 1075 (D. Ariz. 1976) (explaining that a deed of trust is “an essentially private contractual arrangement”). In light of the explicit terms of the standard deed signed by Cervantes, it does not appear that the plaintiffs were misinformed about MERS’s role in their home loans."

In relying on the language of the deed of trust, the Ninth Circuit's decision may have far-ranging implications for other cases where the MERS system is being challenged by borrowers individually and in putative class actions.

 

AIG Derivative Lawsuit Dismissed

A derivative shareholder lawsuit against AIG was recently dismissed by a federal court judge in New York.  Should this give comfort to other directors and officers in litigation resulting from the financial crisis?  After all, if a court did not allow claims against management in the wake of the stunning collapse of AIG -- a collapse which almost brought down the entire financial system with it -- how could claims against management of other companies that run into to trouble succeed?  However, because the dismissal was based on the defendant shareholders failure to make a pre-suit demand on the board of directors to file a suit against the company's management, the case may not give much solace to other directors and officers.

In the AIG case, the plaintiff-shareholders alleged that the defendants had failed to properly oversee the company’s credit default contracts and had made misleading statements about the company’s financial health and risk management. The plaintiffs also allege defendants wasted corporate resources and breached their fiduciary duties when they caused AIG to increase its dividend and buy back its stock in the months leading up to the company's collapse and government rescue.

The case was brought by shareholders on behalf of the company in what is known as a derivative shareholder suit.  Because of the nature of these derivative actions, there are special procedures to allow the company to intervene and decide whether it is in the company's best interests to assert any claims against its own current or former officers and/or directors.  One procedural rule requires shareholders who wish to bring derivative actions to first issue a demand upon the corporation to bring the claims.  The demand requirement may be excused where the shareholder demonstrates that a demand would be futile.

In the AIG case, the defendants moved to dismiss the case because the plaintiff failed to make a presuit demand.  The plaintiff-shareholder contended that demand would have been futile because AIG's board was conflicted and inherently biased against asserting the claims.  The judge disagreed and granted the defendant's motion, reasoning that five of the nine directors at AIG in June 2009, when the lawsuit was filed, were disinterested and therefore demand was not excused.

The plaintiffs tried to argue that all of the directors were interested because they faced personal liability even though they were not directly involved in any of the problems in AIG's credit default swap/derivatives unit which took the company down.  Plaintiffs claimed that these directors breached their duty of oversight.  The court notably rejected this argument, and relied on the Delaware Chancery Court's decision dismissing a similar derivative lawsuit against Citigroup, and wrote that plaintiffs "may not support a claim based on the duty of oversight…merely by identifying signs of general difficulty in the market in which the company participates and asserting that the defendants should be held liable for exercising their business judgment in a manner that appears to have been inconsistent with those indications."

As to the allegations about the issuing dividends and the stock buy-back, the court also found that AIG directors did not face liability:

"AIG’s decision to increase its dividend by a modest ten percent redounded to the benefit of all
shareholders equally and presumably, in the short term, made AIG’s stock more attractive to
investors, thereby heightening demand for the stock, increasing the share price, and potentially
lowering the Company’s cost of capital. Although Plaintiff baldly alleges that “the dividend
declaration was directly tied to the desire to compensate certain Officer Defendants,” Plaintiff
pleads no particularized facts to render this inference plausible. The Court cannot conclude that
this decision was “so egregious or irrational that it could not have been based on a valid
assessment of the corporation’s best interests.”

The case is American International Group Inc 2007 Derivative Litigation, U.S. District Court, Southern District of New York (Manhattan), No. 07-10464.

The Heightened Risk Of Doing Business With The Government

One risk for directors and officers of banks or other financial institutions in taking money and support from the Federal Government is the potential increase in exposure for criminal liability for statements made in applications for TARP money or other assistance.  If the financial institution that receives money later fails, there will be heightened scrutiny of that institution's paperwork.  The result could be allegations that any inaccuracies in those papers, with the benefit of hindsight, were recklessly or intentionally made.

A potential example of this was reported today by Marketwatch (here), where the CEO of Park Avenue Bank, which was closed by bank regulators on Friday, was arrested for allegedly making false statements on a TARP application, among other charges.

Here Come The Failed Bank D&O Lawsuits

The State of Georgia is leading in one financial category in which it would rather not lead -- it has seen one of the highest incidents of failed banks in the Country.  Now, it may also be at the leading edge of litigation against directors and officers following the bank failures.  As reported yesterday in the Atlanta Journal Constitution (here), investors in the failed Georgia bank, Alpha Bank, have filed a suit against its former officers and directors alleging that they failed to disclose that the bank had deviated from its original business plan by engaging more aggressively in subprime mortgage lending.  Investors also allege that management hid details of a review by bank regulators that raised issues with the bank's lending practices and programs.

Thus far, there has been relatively few suits against directors and officers, but the storm clouds have been gathering.  The FDIC has been gathering information about D&O insurance from failed banks as a precursor to litigation or issuing demands prior to litigation.  This lawsuit, by investors in a bank rather than the FDIC as receiver for a failed bank, may be just the tip of the iceberg. 

SEC Chair Shapiro Calls For Greater Regulation Of ABS

In a recent speech (here), SEC Chairwoman Mary Shapiro urged greater regulation and legislation of Asset Backed Securities because there are "gaps" in regulation of ABS.  The current disclosure-based regime was designed to deal with issuers in actively-managed businesses, Shapiro said, which are not as suitable for ABS, which are less liquid, and are based on underlying pooled assets.  On the legislative front, Shapiro envisioned an entirely new act directed solely at securitizations, which would allow Congress to "specifically tailor solutions for these investment vehicles, much like the Investment Company Act of 1940" -- the law specifically directed at mutual funds.  Although her speech lacked specifics, Shapiro stated that "[s]uch a statute could set minimum requirements for the pooling and servicing agreements, such as requiring strong representations and warranties about the assets being securitized and procedures for ensuring those representations and warranties are followed. That's in addition to the disclosure requirements of the Securities Act, which would continue to apply when ABS securities were offered and sold."

House Passes Sweeping Financial Reform Bill

Given Congress' recent work, one might think that our representatives are being paid by the word.  Following on the heals of the 2,000+ page health care bill, the House of Representatives on Friday passed a sweeping financial and securities regulatory reform bill that checks in at 1,279 pages.  The bill touches virtually every aspect of the financial services industry, and there is a similar bill working its way through the Senate. 

So in an effort to distill down the 1,279 pages, here are some highlights of the "Wall Street Report and Consumer Protection Act of 2009," H.R. 4173 (full text available here) :

• Creation of a Consumer Financial Protection Agency to oversee consumer protection in financial products ranging from credit cards to mortgages.
• Creation of a new Financial Stability Council to regulate and potentially unwind financial institutions that are "too big to fail."  This includes an FDIC-type charge on large banks to set aside $150 billion for possible costs of this new regulation and potential failure of such a large institution.
• Creation of a single federal banking regulator.
• Creates a Federal Insurance Office within the Treasury Department, although it would have more of a monitoring and advisory role - the front-line regulation of insurance companies would still lie with the States (at least initially).
• Introduces various regulatory reforms for trading derivatives and credit default swaps, including requiring dealer banks and major swap traders to trade some of their routine products on transparent platforms and steer the swaps into clearinghouses, which guarantee trades;
  giving the SEC and CFTC new police powers for over-the-counter derivatives and lets the CFTC set trading limits on swaps that play a role in setting market prices; imposing new capital, margin, reporting, record-keeping and business conduct standards on swap dealers and major swap traders; and preventing bank dealers and major traders from collectively owning more than a 20% controlling stake in swap clearinghouses or trading platforms.
• Requires hedge funds and private equity funds to register with the SEC
• It doubles SEC funding over five years.
• Gives shareholders an advisory vote on executive pay in connection with proxy voting each year.
• Allows the SEC to prohibit arbitration clauses in broker or investment advisor agreements for claims brought by customers of the broker for violations of the securities laws.
• Extends aiding and abetting liability for claims brought by the SEC for violations of the Securities Act of 1933 and the Investment Advisors Act of 1940.  It DOES NOT overrule the Supreme Court's Stoneridge decision, and permit aiding and abetting cases brought by private litigants under the Securities Exchange Act of 1934.
• Clarifies the extra-territorial reach of U.S. securities laws, and expressly permits claims brought by foreign purchasers of securities on foreign exchanges as long as conduct in the U.S. substantially furthers the securities violation or conduct outside the U.S. has a foreseeable substantial affect inside the U.S.
• Expands the SEC's subpoena power in civil cases, allowing service nationwide and exempting the SEC from certain requirements of Rule 45 that other litigants must meet (and which are usually for the protection of non-party witnesses).

They sure have been busy in Washington.  Once the bill is reconciled with the version still moving through the Senate, the myriad of new regulations should also keep compliance personnel, general counsel, and their outside lawyers busy as well.

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.

So Far Treasury Is Making Money On Investments In Banks

Beginning back in June, some of the larger banks began buying back the Treasury Department's preferred securities the Government purchased as part of the TARP Capital Purchase Program.  You remember TARP (Troubled Asset Relief Program), right?  It was passed as part of the Emergency Economic Stability Act (EESA) at the height of the credit crisis almost one year ago in the days following the collapse of Lehman Brothers, AIG and Bear Stearns.  There was no shortage of debate or controversy at the time either.  Many saw the $700 billion TARP program as a give-away to the Wall Street businesses that people thought got us into this mess.  Others saw it as vital to preventing another Great Depression, and worth risking the "moral hazard" dilemma.  Besides, those in support of the plan argued, if the banks survive, then the government might get paid back most of its $700 billion anyhow.

Although it may be too early to count TARP as a worthy gamble, it is interesting that, at least so far, the American Taxpayer has actually made money on the Government's investment in the nation's banks.  Every few days, the Treasury Department releases a completed transactions report (latest one available here), that shows where the TARP money has gone, as well as the money that has been paid back.  So far, 41 financial institutions have repaid the principal invested by the government.  However, most also bought back the warrants issued as part of the purchase of preferred stock by the government.  In doing so, the government has made about $2.89 billion on its investment, not including interest payments that were made during the time that the government was a preferred shareholder.  About $70.5 billion of the total $200 billion invested in financial institutions has been paid back, with Citigroup indicating yesterday that it might be prepared to raise sufficient capital to buy out $20 billion of Uncle Sam's $45 billion investment in that company as well (article here).  If the Treasury Department can make a similar return on investment on the remaining $130 billion investment in America's financial institutions, I think most taxpayers would be quite pleased indeed.  Somewhere, Hank Paulson is smiling.

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.