Subprime Litigation Wave Hits Merrill Lynch

Investors undoubtedly were angry after Merrill Lynch announced on October 24, 2007 (here) that the company’s 3rd quarter results included "write-downs of $7.9 billion across CDOs and subprime mortgages, which are significantly greater than the incremental $4.5 billion write-down Merrill Lynch disclosed at the time of its earnings pre-release." The $3.4 billion write-down increase less than three weeks after Merrill’s October 5, 2007 pre-release (here) perhaps made in inevitable that the lawsuits would fly, and so it comes as no surprise that on October 30, 2007, the Coughlin Stoia firm filed a complaint against Merrill Lynch and for of its directors and officers (including its now-former Chairman and CEO, Stanley O'Neill). The law firm’s October 30 press release about the case can be found here. The complaint can be found here.

The complaint is filed on behalf of shareholders who purchased Merrill Lynch stock between February 26, 2007 and October 23, 2007, and alleges that (as summarized in the press release):

during the Class Period, defendants issued materially false and misleading statements regarding the Company’s business and financial results. Merrill had gone heavily into Collateralized Debt Obligations ("CDOs") which generated higher yields in the short term but which would be devastating to the Company as the real estate market continued to soften and the risky loans led to losses. According to the complaint, Defendants knew or recklessly disregarded that: (i) the Company was more exposed to CDOs containing subprime debt than it disclosed; and (ii) the Company’s Class Period statements were materially false due to their failure to inform the market of the ticking time bomb in the Company’s CDO portfolio due to the deteriorating subprime mortgage market, which caused Merrill’s portfolio to be impaired.

While at one level it is not surprising that Merrill Lynch has been targeted, there are reasons to wonder about the lawsuit filing. The most specific question relates to damages. Even though Merrill’s stock price dropped from 65.56 at a closing price of 63.22 on the day the larger than expected write down was announced, the stock closed today (October 30) at 65.56, just 2.34% less than the opening price on the day of the announcement. The plaintiffs apparently seek to augment these apparently shallow damages by stretching the purported class period back to February 2007, when Merrill’s stock was trading over 97. But the plaintiffs will have a difficult time establishing loss causation for the portion of the share price decline that preceded the October 24 announcement. The plaintiffs may try to claim that Merrill dribbled the corrective disclosure in two pieces, the pre-release and the actual release. Merrill’s share price opened at 76.67 the day of the pre-release, so plaintiff’s may try to rely on the decline from that point, but the emotional appeal of the case is the unexpected increase in the amount of the write-down, which of course came later and after the share price was already beaten down.

There is another sense in which the Merrill lawsuit is puzzling, at least from a detached point of view. It is arguable that all Merrill did was to try to get full disclosure of the deterioration in its subprime-backed assets out into the financial marketplace. As an October 30, 2007 Wall Street Journal editorial noted (here), while Merrill’s write-down was a "big surprise" suggesting that "oversight was late in coming," the write-down "implies that Merrill did the right thing by taking a good hard look at its books before reporting its results," while, the Journal notes, "some other banks haven’t been so candid." The implication is that other investment banks have avoided the obloquy Merrill has faced simply by soft-pedaling their disclosure.

Whether or not Merrill was more forthcoming that its peers, it is clear that many more write-downs will be coming. For example, UBS, which pre-announced on October 1, 2007 (here) that it would be taking a $3 billion write down in mortgage related assets, announced on October 29, 2007 (here) that "further deterioration in the U.S housing and mortgage markets as well as rating downgrades for mortgage-related securities … could lead to further write-downs." As the October 28, 2007 article on the online version of The Economist asked (here), "is Merrill the tip of the iceberg?" It seems probable, indeed inevitable, that there are further write-downs to come. More difficult to discern is who will be taking the write-downs and for how much (about which refer to my prior post, here).

In any event, I have added the new Merrill Lynch lawsuit to the running tally I am keeping of the subprime lending lawsuits (which can be found here). I fear there are many more cases to come.

Two Other New Real Estate-Related Lawsuits: Two other lawsuits filed this week, while not directly attributable to the subprime mortgage meltdown, definitely arise from previously frothy conditions in real estate lending, and reflect the current strained credit market conditions.

The first, filed on October 29, 2007, alleges, according to the plaintiffs’ lawyers press release (here), that BankAtlantic Bancorp and certain of its directors and officers "materially understated reserves for real estate loan losses on its financial statements." The complaint also alleges that the bank gave a $27.8 million real estate loan to two borrowers without first getting an appraisal of the Florida property involved, which the borrowers were allegedly using as a part of a scheme to obtain real estate loans with inadequate collateral. The bank later had to increase its loan loss reserves as a result of problems with its Florida real estate portfolio.

The second, filed on October 30, 2007, alleges, according to the plaintiffs’ lawyers press release (here), that CBRE Realty Finance and certain of its directors and officers, in connection with the company’s September 2006 IPO, failed to disclose that "at the time of the IPO more than $20 million in loans on the company’s books were impaired and should have been written down but were not." When the company announced in August 2007 that it was taking a $7.8 million impairment charge due to a foreclosed asset, the company’s share price declined.

Even though these two new lawsuits are not subprime-lending related, they show that deteriorating real estate market conditions and the turbulence in the credit sector are stressing many companies, not just those involved in subprime lending, and also generating additional lawsuits. There undoubtedly will be more to come.

Happy Birthday to the Drug and Device Law Blog: The Drug and Device Law blog has celebrated its first anniversary with an interesting note (here) reflecting on the burdens and rewards of the blogging life. Because the post captures so many of my own thoughts (particularly about how hard blogging is), I have linked to it here. And I would be remiss if I did not also wish happy birthday to an excellent blog.