As Joshua Silverman reports in the December issue of The Pomerantz Monitor, pension funds around the globe have lost hundreds of billions of dollars in the recent mortgage and credit market meltdown. Increasingly, they are turning to U.S. courts to seek recovery of these losses.
Most claims are brought as class actions. In recent years, European funds have begun to play a more prominent role in these cases. The National Association of Pension Funds, a U.K. industry association, estimates that 23% of British pension funds have now actively participated in a U.S. securities class action.
With the economic crisis emanating from a downfall in housing prices, it is no surprise that many lawsuits target companies connected in some way to subprime lending. According to The D&O Diary, a blog that tracks these lawsuits, 126 subprime-related securities fraud class actions have already been filed in U.S. courts. Of these, 21 relate to illiquid auction rate securities (ARS) falsely marketed as cash equivalents. Most banks have settled ARS claims under pressure from U.S. regulators. However, some of these settlements leave institutions with the largest losses out in the cold. Credit Suisse, for example, only agreed to redeem ARS positions of $10 million or less.
Targets in the remaining suits run the gamut from banks to REITs to homebuilders to mortgage lenders. European funds will be particularly affected by three categories of these suits.
Suits Against Financial Services Companies: No industry has destroyed more investor wealth over the past year than the American financial service industry. Shareholders in storied institutions like Bear Stearns and Lehman Brothers lost virtually all of their investments, despite assurances from management that capital was sufficient. AIG had to sell over 80% of itself to the federal government after credit default swaps swallowed the firm’s operating capital.
Class actions are pending against all of these firms, plus Citigroup, Wachovia, BankAtlantic, BankUnited, Fifth Third, National City, and others. Most suits allege that the banks were heavily exposed to risky subprime and Alt-A loans but did not fully disclose this risk to shareholders, or misvalued credit instruments in their financial statements.
Many banks, seeking to raise badly needed capital in the wake of massive asset write-downs, also recently came to market with new issues of common stock, preferred stock and trust preferreds, “TruPS” (junior subordinated debt issued indirectly through a special-purpose trust). Investors who bought positions in (or traceable to) these offerings may have a leg up under the Securities Act of 1933, which is limited to securities offerings, and allows recovery for inaccurate statements in an offering document without proof of fraudulent intent.
A major question in suits against banks is whether they have the ability to satisfy a large judgment or enter into a reasonable settlement. Many banks have already gone under or are hanging on by a thread. But even failed banks generally have D&O insurance, and there may be other viable defendants like underwriters.
Suits Involving Structured Financial Instruments: To rid their balance sheets of toxic loans, U.S. banks and mortgage originators packaged them into mortgage-backed securities (RMBS), some of which were further repackaged into collateralized debt obligations (CDOs).
The banks heavily marketed both RMBS and CDO securities to European and Asian institutional investors. Many RMBS and virtually all CDO prices plummeted as the market learned that the underlying loans were low quality and borrowers were defaulting at alarming rates.
Investors in some RMBS securities are fighting back. For example, a number of purchasers of Countrywide RMBSs have filed putative class actions or individual claims alleging that the registration statements and prospectuses falsely described a stringent origination process that was supposed to ensure that the collateral consisted of viable loans.
Investigations into Countrywide by several state attorneys general and the FBI suggest that these assurances were false. Instead, it appears that a large portion of the loans were actually the result of mortgage fraud. Former Countrywide brokers and appraisers now admit that they were encouraged to falsify paperwork or bypass guidelines to get unqualified loans funded. Government officials are also investigating similar accusations of origination fraud by IndyMac, Washington Mutual, and Wachovia. To date, those banks have not been named as defendants in suits by RMBS investors.
CDO claims are substantially more difficult in American courts because CDOs are not registered under the Securities Act of 1933. Therefore, CDO investors do not enjoy protections under that statute and generally are forced to proceed under difficult state law theories.
Litigation may also emerge regarding constant proportion debt obligations (CPDOs), structured financial instruments sold primarily to European investors. Moody’s admitted that it issued flawed ratings for CPDOs sold by Elm B.V., Castle Finance, Cairn Finance and Coriolanus, and later failed to correct the flaws or alert investors.
Suits Involving Agency Obligations and Pre-ferreds (e.g. Fannie Mae/Freddie Mac): European investors were large holders of agency debt and preferred shares issued by Fannie Mae and Freddie Mac. In early September, after accounting and operational deficiencies eroded their respective capital bases, the U.S. Treasury Department placed them in conservatorship. Common shares lost most of their value and preferred shares declined as much as 90%. While the government’s rescue plan protected senior debt and securitized offerings, it provided no support to common or preferred shareholders.
A number of institutions that purchased various series of Fannie Mae and Freddie Mac preferred stock in late 2007 and 2008 offerings have brought claims against the issuers and underwriters. Reports by OFHEO, a regulatory body, and Congressional investigators may bolster investors’ claims that the companies concealed capital deficiencies by inflating the value of mortgage and tax assets.
Suing in U.S. Courts: In previous issues of the Monitor we explained the many advantages for foreign investors in bringing their cases in U.S. courts. European funds that purchased shares on U.S. exchanges have the same access to American courts and an equal right to be appointed lead plaintiff as American investors. They may also have a right to pursue claims in American courts for securities they purchased elsewhere if the issuer is a U.S. entity, U.S. investors have been substantially harmed or, in certain situations, if the misconduct occurred principally in the United States. In Morrison v. National Australian Bank, for example, the Second Circuit court of appeals reaffirmed that so-called “f-cubed” actions, involving foreign securities bought by foreign nationals on a foreign exchange, can properly be brought in U.S. courts if these requirements are satisfied.
There are three ways that a European fund can participate in American securities fraud cases: (1) a fund with large losses can seek to be appointed lead plaintiff; (2) it can monitor the class action and file a claim form once a settlement is reached or a judgment is obtained; or (3) it can “opt out” of the class action and file an individual claim.
Opt-out claims are beginning to play a larger role, and for good reason. In recent cases not involving subprime lending, both American and European institutions secured much greater recoveries by pursuing their own opt-out claims. For example, in the AOL/Time Warner case, both European and U.S. funds opted out, and some have reported that they achieved settlements several times higher than they would have received as members of the class action.
Either way, European funds are certain to remain a fixture in U.S. securities litigation.
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