Subprime Litigation Wave Hits Citigroup

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In the days following Citigroup’s November 4, 2007 announcement (here) that it would be writing off an additional $8 to $11 billion due to declines in values of U.S. subprime related debt exposures, as well as its announcement (here) of the departure of its Chairman and CEO Charles O. Prince, the company has been hit with a heap of lawsuits, making it the latest company to be caught up in the subprime lending-related litigation wave.

The first lawsuit, initiated on November 6, 2007, was filed by a Citigroup employee on behalf of participants and beneficiaries of the Citigroup 401(k) plan and the Citibuilder 401(k) plan of Puerto Rico, for alleged violations of ERISA in connection with the loss of value in the Citigroup stock held in the plans. A copy of the plaintiff’s counsel’s press release can be found here, and the complaint can be found here. The complaint names as defendants the company, Prince, and the plans’ administrative and investment committees. According to the press release, the complaint alleges that

Citigroup and the various defendants breached their fiduciary duties owed to the Plans’ participants by: (1) failing to prudently and loyally manage the Plans’ assets; (2) failing to provide participants with complete, accurate and material information concerning Citigroup’s business and financial condition necessary for participants to make informed decisions concerning the prudence of directing the Plans to invest in Citigroup stock; and (3) failing to appoint and monitor the performance of the other fiduciaries. Citigroup’s exposure to the subprime market and its contingent liabilities with respect to various off-balance sheet transaction has led to the resignation of Citigroup’s CEO and caused the Plans to suffer well over $1 billion in market losses.

Next, on November 7, 2007, a Citigroup shareholder filed a shareholders’ derivative lawsuit (here), against the Company as nominal defendant, and numerous present and former directors and officers. The complaint alleges "breaches of fiduciary duties, waste of corporate assets, unjust enrichment, and violations of the Securities Exchange Act of 1934." The complaint alleges that the violations took place between January 2007 and the present and caused substantial monetary loss to the largest U.S. bank and other damages such as to its reputation and goodwill. A November 7 Wall Street Journal article describing the derivative lawsuit can be found here.

Then on November 8, 2007, a Citigroup shareholder filed a purported securities class action lawsuit against Citigroup and several present and former directors and officers. A copy of the plaintiff’s counsel’s press release can be found here and a copy of the complaint can be found here. (There have been several additional substantially similar securities lawsuit complaints filed against the company.) According to the press release, the complaint alleges that between April 17, 2006 and November 2, 2007,

Defendants issued materially false and misleading statements regarding the company’s business and financial results. The complaint specifically alleges that: (i) Defendants’ portfolio of CDOs contained billions of dollars worth of impaired and risky securities, many of which were backed by subprime mortgage loans; (ii) Defendants failed to properly account for highly leveraged loans such as mortgage securities; and (iii) Defendants had failed to record impairment of debt securities which they knew or disregarded were impaired, causing the Company’s results to be false and misleading.

It is now common to refer to the period earlier this decade when Enron, WorldCom and other corporate meltdowns occurred as the era of the "big corporate scandals, " usually with the unstated implication that this era is well in the past. But with the recent high profile turmoil involving such corporate titans as Citigroup, Merrill Lynch, Washington Mutual and Countrywide Financial, it seems appropriate to ask whether the unfolding subprime meltdown may have evolved into a new (or perhaps renewed) era of corporate scandals.

At a minimum, the subprime mess has generated an impressive amount of high-stakes litigation. As reflected in my running tally of subprime lending-related lawsuits (here), 20 companies have now been sued in subprime-related securities class action lawsuits, in addition to the four residential construction companies and two credit rating agencies that have been sued in securities lawsuits, as well the three lawsuits brought by employees against their employers under ERISA raising allegations pertaining to plan losses arising from the subprime meltdown. At this point, it seems highly likely that there is significant additional litigation yet to come. The subprime mess may not yet have created any massive corporate failures on the scale of the era of corporate scandals from earlier in this decade, but the mess clearly already represents its own distinct (and growing) category of corporate scandal and related litigation.

$3 Billion in Subprime Related D & O Losses?: A recent attempt to quantify the extent of D & O insurance industry exposure from subprime-related litigation appears in the November 2007 publication of Guy Carpenter entitled "Credit Market Aftershock Threatens Professional Liability Profits" (here). The report notes that while the estimates of losses to the D & O insurance industry have varied from $1 billion to $3 billion, "when the dust settles, total insured losses are likely to be at the top end of analyst estimates (i.e. $3 billion), because most reports have understated the D & O limits at risk and assume there will not be many claims beyond what has been filed already."

The report notes further that "there was never any doubt that the subprime mortgage market collapse would have an insurance impact. The question was one of extent. While estimates vary from $1bn to $3bn, it looks like the reality may settle at the upper end of the scale. The final answer will not come until 2008 or maybe even 2009, but history, litigation tendencies and capital markets point toward the worst case scenario,” The report goes on to note that "insured losses could account for 30% to 35% of D & O industry premium."

Notwithstanding the scale of the reports projected losses and the extended duration of the loss period, the report speculates that the losses losses are "unlikely to reduce available reinsurance capacity or substantially impair (re)insurers' results of balance sheets."

While I am inclined to agree that with the report's conclusion that losses are likely to range beyond many of current estimates, I think it is simply too early to tell the overall impact on capacity or insurer financial stability. For example, the report's analysis relates only to lawsuits filed only through the end of October, and so omits consideration of the lawsuits already filed in November, such as the new lawsuits against Merrill Lynch, Citigroup, and Washington Mutual. The filing of these lawsuits, and the suddenness of their emergence, does tend to underscore the likelihood that losses will range higher than previously assumed, but the unanticipated emergence of the lawsuits against these corporate giants also suggests that the subprime problem may be even bigger than Guy Carpenter assumed when drafting its report. So while I agree with the report that the subprime problem is shaping up to be bigger than previously assumed, it is simply too early to predict whether or not it will impact capacity or insurer financial strength. It is worth emphasizing that the situation is worse than Guy Carpenter assumed when they wrote their report.