Mortgage Meltdown

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

2009-11-10T17:12:33-06:00

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

2009-09-24T12:48:18-05:00

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

2009-09-17T14:40:31-05:00

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

2009-09-10T11:15:24-05:00

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?

2009-07-23T22:49:00-05:00

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.

Despite Efforts, Tide of Foreclosures Continues

2009-07-16T10:07:41-05:00

Despite efforts by States, the Federal Government, and private initiatives to reduce foreclosures, they appear to continue unabated (article here). Foreclosures in the second quarter of 2009 increased 20% over last year to a record level of nearly 890,000, according to RealtyTrac. In Nevada 1 out of every 34 housing units is in foreclosure. In California 391,600 properties were subject to foreclosure filings.

DOJ Antitrust Division Looks Into CDS Pricing Issues

2009-07-14T12:05:11-05:00

As reported by the Wall Street Journal (here), the Antitrust Division of the Department of Justice is investigating potential violations in the Credit Default Swap market, asking for information from Markit Group Holdings Ltd. Markit was a key player in the explosion of the CDS market from virtually nothing into the $38 trillion market that it became. Although not an exchange, Markit Group collected information from banks and brokers and published prices for various swaps.

So who is Markit Group Holdings? Well, its largest shareholders include many of the large investment banks on Wall Street, including J.P. Morgan, Goldman Sachs, Citigroup, Deutsche Bank, Bank of America, Barclays, UBS, and Morgan Stanley. Although the article is scant on details of the potential antitrust violations DOJ is investigating, the fact that all of the large banks banded together and created a company that basically set the prices of such a large market seems at least create the opportunity for manipulation of the market, manipulation of pricing, and the ability to keep any other company interested in competing with Markit Group frozen out of the business.

(photo courtesy of freefoto.com)

Treasury Issues New Rules on Executive Compensation for TARP Participants

2009-06-17T00:46:35-05:00

Late last week, the Treasury department issued an interim final rule (somewhat of an oxymoron, but that is what it is called) entitled "TARP Standards for Compensation and Corporate Governance." The Treasury Department was given this authority under the Emergency Economic Stabilization Act of 2008 passed last October in the deepest part of the crisis and amended by the American Recovery and Reinvestment Act of 2009, passed following the dust-up about retention bonuses provided to certain executives at AIG. The full text of the regulation is available here (beware, it is 123 pages). It supercedes the executive compensation interim rule issued after the EESA by incorporating the greater restrictions on executive comp in the Recovery Act.

The limits apply to those executives named in the company's proxy statements as well as a certain number of "the most highly compensated employees" at each firm. The number of these employees that are subject to the regulations varies depending on how much financial support the firm has received under TARP. For example, for those institutions receiving over $500 million in assistance, the five senior executive officers and the 20 most highly compensated employees are covered.

First, the regulation provides guidance to executive compensation committees at the TARP recipient to comply with the requirements of the EESA that it structure compensation to limit unnecessary short-term risk taking by management. The committee must review, evaluate and report about the executive compensation of the named executives and highly compensated employes every six months. The report, which must be filed with the SEC, has to include "a narrative description of how [executive compensation] plans do not encourage [executives] to take unnecessary and excessive risks that threaten the value of the TARP recipient."

Second, the regulation provides for the recovery of any bonus, retention awards or other incentive compensation paid based on materially inaccurate earnings, revenues, gains or other performance criteria that caused the bonus to be paid. The new rule requires that the TARP recipient actually exercise its clawback rights in such a case unless the TARP recipient can demonstrate that it would be unreasonable to do so (for example, if the expense of enforcing the clawback right exceeds the benefits of doing so). It is still unclear how this gets enforced if the government disagrees either (1) with the company's decision that a bonus was not paid based on materially inaccurate information; or (2) does not exercise its clawback rights or determines it would be unreasonable to exercise them.

Third, it further curtails so-called "golden parachutes." Aside from extending the restriction to a larger class of employees, the new rule also curtails payments made to executives leaving a company due to a change in control, such as an acquisition or merger with another company.

The rule also creates a "Special Master" to oversee executive compensation at firms receiving "exceptional assistance" under TARP. Currently, the group deemed to have received exceptional assistance includes AIG, Citigroup, Bank of America, Chrysler, GM, GMAC and Chrysler Financial. He will review compensation to named executives and the 100 most highly compensated individuals. These company's must get compensation packages for these individuals approved by the Special Master, who may reject them if he deems them inconsistent with the goals of TARP. However, compensation will automatically be approved -- a so-called safe harbor -- if the compensation does not exceed $500,000.

Finally, the rule sets forth a number of requirements that were not explicitly included in the EESA or the Recovery Act. The rule prohibits the payment to senior executive officers and the 20 next most highly compensated employees of a tax "gross-up," or a payment to cover taxes due on compensation such as golden parachutes and perquisites. TARP recipients will be required to disclose any perquisites provided to any employee subject to the Recovery Act's bonus limitations with total value exceeding $25,000. TARP recipients will also be required to provide a nar rative description of, and justification for, the benefit. The rule also requires financial institutions to disclose the use of compensation consultants and the methodology used by the consultant, such as "benchmarking" procedures in the consultants analysis.

Catching Up

2009-06-03T10:58:20-05:00

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 SEC Chair Weighs In On Ratings Agencies

2009-04-19T23:57:31-05:00

The credit rating agencies that provided securities packaging subprime mortgages with investment grade ratings have been in the cross-hairs of regulators and plaintiffs since the mortgage meltdown first began in the spring and summer of 2007. Yet very little has been done to change the way that they are regulated.

So last week new SEC Chairwoman Mary Schapiro hosted a round table on what more should be done. Many see the fundamental problem with the current structure is that the rating agencies are generally paid by the issuer or underwriting of the security they are asked to rate. This "issuer-paid model" accounts for 98% of all bond ratings. There is an inherent conflict of interest in this model, where issuers will shop around for the highest rating.

Although the SEC has adopted some new regulations to address this conflict of interest problem (for example prohibiting any employee involved in rating a issue to also be involved in the fee negotiations), Ms. Schapiro acknowledged there was more to do. Many of the proposals at the meeting focused on solving this conflict of interest dilemma. Some participants suggested all firms should be required to switch to an investor based model, or have the rating fees paid out of a portion of the bonds' interest payments. Others went further, suggesting that a new regulatory body, similar to the Public Accounting Oversight Board (PCAOB), should oversee rating agencies.

Ms. Schapiro suggested that the structure the SEC set in place when it settled a 2003 enforcement action with ten of the largest investment banks could be applied to rating agencies as well. The settlement, which resolved claims that the investment banks provided slanted research in companies in which they had a financial interest, required the banks to distribute independent research along with the firm's own research in certain circumstances.

Legislators are apparently getting involved as well. According to a Wall Street Journal article (here), Senator Schumer is considering introducing a bill that would require rating agencies to separate any consulting business from the ratings business. Another Senator, Jack Reed, would outsource the regulation to the class-action bar. He supports passing legislation that would make it easier for investors to bring class action securities lawsuits against the rating agencies (rating agencies have traditionally had success asserting a first amendment privilege, claiming that, like a newspaper, they simply provide information to the public).

Putting the legislative proposals aside, I think that the PCAOB-like oversight structure may be worth pursuing, particularly if nothing is done about changing the issuer-paid model. Moreover, the issuer-paid model does seem to support capital formation by allowing the most bonds to get ratings, so we may not want to do away with it entirely.

Coverage of the roundtable is available here, here and here.