A Closer Look at the 2007 Subprime-Related Securities Lawsuits

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In its 2007 year-end study of securities class action trends (here), NERA Economic Consulting noted that the "sharp increase" in 2007 securities lawsuit filings was "driven in part by litigation related to subprime lending," an observation I have also noted elsewhere. Given the importance of the subprime lawsuit filings to the overall 2007 securities lawsuit picture, it is worth taking a closer look at the 2007 subprime-related securities lawsuits.

As a preliminary matter, it should be noted that I have counted 34 subprime-related securities lawsuits during 2007 (as detailed here), whereas in its year-end report NERA stated that there were 38 subprime-related lawsuits. The difference may be merely definitional, as it became harder to classify cases as the year progressed. NERA may also have superior information, a not unlikely possibility given that my data are derived solely from publicly available sources. In any event, readers should be aware that the analysis in this post is limited to the 34 lawsuits in my tally.

The 34 companies sued in the subprime-related lawsuits represent 15 different Standard Industrial Classification (SIC) Codes. The largest concentration of cases is in the 6798 SEC Code (Real Estate Investment Trusts), which accounted for 11 of the34 cases. Fully 30 of the 34 companies sued fall within the 6000 SIC Code Series (Finance, Insurance and Real Estate).

Another way to look at the companies is by industry, rather than by SIC Code. As might be expected, there are more companies is in the banking/mortgage lending business than any other industry; this group accounted for 12 of the companies sued. Other industry groups with multiple companies represented included residential home builders (5), REITs (5), Bond Insurers (3) and Credit Rating Agencies (2). Other industries represented with one company each include mortgage investment companies, mutual funds, and savings and loans. (The list of companies also includes Freddie Mac, which as a government sponsored entity is hard to classify.)

The subprime-related lawsuits were filed in 15 different federal district courts, with the largest number filed in the Southern District of New York (11). Other courts with multiple filings include the Central District of California (6), Eastern District of Pennsylvania (3) and the Northern District of California (2).

The list of companies sued includes two that are domiciled overseas: UBS (Switzerland) and Security Capital Assurance (Bermuda). One of the subprime-cases – the one involving Security Capital Assurance – involves IPO-related allegations.

The 34 subprime-related lawsuits were filed between February and December 2007, with at least one lawsuit filed in each month during that period. There were two in February, four in March, two in July, eight in August, four in September, two in October, five in November, and four in December.

In other words, the subprime-related lawsuits, while concentrated in the Finance, Insurance and Real Estate SIC Codes, represent a number of different industries. The lawsuits have been filed in a number of different courts, but with a concentration in New York and Los Angeles. The lawsuit filings were spread (albeit somewhat unevenly) throughout the year. These observations seem relevant to any analysis of what the cases might represent within the larger context of securities filing trends.

Mortgage Investigations Face Challenges: A December 27, 2007 Washington Post article entitled "Mortgage Probes Face Big Hurdles" (here) notes that as problems have emerged following the subprime mortgage meltdown, "government subpoenas are flying, investor lawsuits are mounting, and in the nastiest cases, businesses are pointing the finger of blame at one another. "

But despite the almost irrepressible urge to find scapegoats, investigators could face significant hurdles due to the "tangled system" of regulatory authority and oversight. In addition, another consideration that could stymie investigators, and that could be a factor in the many investor lawsuits, is that "many of the assets that tumbled were explicitly marketed as involving borrowers with trouble credit histories, alerting investors that they were high-risk bets."

White Collar Fraud is Not Just Wrong, It’s Insane!: Regular readers may recall my prior post (here) about former Crazy Eddie CFO (and convicted felon) Sam E. Antar, who is now making a name for himself warning others about how to spot fraud. A lengthy December 25, 2007 Fortune Magazine article entitled "Takes One to Know One" (here) takes a closer look at Antar. and his current campaign to combat fraud.

The detailed article reviews the Crazy Eddie fraud in depth and explains how Antar has become a roving lecturer on accounting fraud. The article summarizes Antar’s strategy for finding fraud as "sustained and disciplined paranoia." He also says that the only safeguards against accounting fraud that work are "stringent disclosure rules for companies and better fraud training for auditors."

Interested readers may want to check out Antar’s blog, White Collar Fraud (here), for further commentary from Antar, who signs his blog posts as follows: "Respectfully, Sam E. Antar (former Crazy Eddie CFO and convicted felon)."

Top Ten D & O Stories of 2007

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With the year-end fast approaching, it is time to take a look back and review the top D & O stories of 2007. It was an eventful year, with some important developments that will have implications for the year ahead, and perhaps for years to come. Here are the top stories, with the year’s most important story leading the way.

1. Subprime Meltdown Launches Litigation Wave: When I first started tracking subprime-related litigation in April (here), I already knew that the subprime meltdown was going to be an important story. By July (here), I knew that the subprime story was "this year’s model"—that is, the hot litigation trend being driven by the business scandal most prominent at the time. By August, I wrote (here) that the developing story had become "All Subprime, All the Time." But even at that point, I don’t think I really appreciated what the subprime story would become. I certainly didn’t envision that it would lead to a surge of lawsuits against some of the giants of the financial services world, such as Merrill Lynch (refer here), Citigroup (refer here), Washington Mutual (refer here), and UBS (refer here).

As of year end, my current tally (refer here) of subprime-related lawsuits stands 34; the recently released NERA year-end securities litigation survey (here) put the number at 38. The litigation includes lawsuits against accountants (here), real estate brokers (here), and many others. The securities lawsuits have come not just against the lenders and the investment banks, but home builders, bond insurers, credit rating agencies, mutual funds, and a host of others. Even more ominously, there is an unmistakable sense of foreboding that the worst may lie ahead (refer here). But whatever may actually lie ahead, there is no doubt that the litigation resulting from the subprime meltdown is the 2007 D & O story of the year.

2. Two-Year Lull in Securities Filings Comes to an End: In mid-year 2007 studies, NERA (here) and Cornerstone (here) both observed that securities filings had been well below historical averages since mid-2005. Stanford Law Professor Joseph Grundfest questioned (here) whether or not there might have been a "permanent shift" to a lower level of securities lawsuit filings.

But as I detailed more thoroughly here, and as further documented in NERA’s recent 2007 year end survey (here), the two-year lull came to an end in the second half of 2007. Indeed, the 81 securities lawsuits filed during the period between August 1, 2007 and November 30, 2007 represents the highest level of lawsuit filings in a four-month period since June-October 2004, and the 25 new securities lawsuits filed in November 2005 represents the highest monthly total since January 2005.

Perhaps even more noteworthy is the fact that the new lawsuit activity is not being driven exclusively by the subprime litigation wave; while the subprime lawsuits collectively represent one important factor, the lawsuits are actually hitting a wide variety of companies for a wide variety of reasons, many having nothing to do with the subprime meltdown. The likelihood of continued financial marketplace volatility suggest that litigation levels may remain elevated for some time to come.

3. Supreme Court Issues Tellabs Decision: The Supreme Court does not take many securities cases; for that reason, and because the Tellabs case had the potential to significantly affect the threshold resolution of many securities cases, the Supreme Court’s opinion in the Tellabs case was much anticipated. When the Tellabs opinion finally came out in June 2007, it was a victory for defendants, although perhaps not as extensive a defense victory as it could have been, as detailed further here and here.

The Tellabs opinion reversed the Seventh Circuit’s ruling and held, interpreting the securities lawsuit pleading standards described in the Private Securities Litigation Reform Act, that for an inference that a defendant acted with scienter to be "strong," the inference "must be cogent and at least as compelling as any opposing inference of nonfraudulent intent." The majority opinion expressly rejected the position urged by concurring Justices Scalia and Alito that "the test should be whether the inference of scienter (if any) is more plausible than the inference of innocence."

While the Tellabs court’s more balanced approach seemed less likely to have a dramatic impact on dismissal motions as would the position urged by the concurring justices, the early returns suggest that the Tellabs case has made it more difficult for securities cases to survive a motion to dismiss (as discussed on this post on the 10b5-Daily blog, here). The Tellabs case has, in fact, proven to be an important factor in many of the motions to dismiss in the options backdating cases (about which refer here). The Tellabs decision and the Supreme Court’s 2005 opinion in the Dura Pharmaceuticals case are now important tools for defendants to try to use at the motion to dismiss stage in securities class action litigation.

4. Top Plaintiffs’ Lawyers Face Criminal Woes: Even a short time ago, who would have thought that the two leading securities plaintiffs’ attorneys would face criminal prosecution? Yet on October 29, 2007, Bill Lerach entered a guilty plea (refer here), and on September 20, 2007, Mel Weiss was indicted on criminal charges (here). (For more about Lerach’s criminal charges, refer here; for Weiss’s, refer here).

The impact of the criminal issues involving the two leading securities plaintiffs’ lawyers is perhaps incalculable, but it does not seem a mere coincidence that shortly after Lerach left his former law firm (now reconstituted as Coughlin, Stoia,Geller, Rudman & Robbins) the firm seemingly went into high gear, filing numerous new securities class action lawsuits. The Milberg Weiss firm, meanwhile, which also faces its own criminal charges, has essentially filed no new lawsuits since 2005.

While there are many opportunistic lawyers hoping to capitalize on the changes at the leading plaintiffs’ firms, it remains to be seen whether any of these firms can duplicate the role that the erstwhile leading firms have played in the past.

5. Largest Derivative Settlement Ever in UnitedHealth Option Backdating Case: The 2006 D & O story of the year undoubtedly was the options backdating scandal. The story has faded from the headlines in 2007 as the subprime scandal has emerged, but the numerous backdating lawsuits (refer here for a complete tally) are now working their way through the system. Although many of the options backdating lawsuits have been dismissed or have settled for relatively nominal amounts (refer here for a complete list of options backdating case dispositions), there have been some exceptions. The most exceptional outcome is the record settlement in the UnitedHealth Group options backdating derivative lawsuit, which apparently represents the largest derivative settlement ever.

As detailed here, in the settlement, former UnitedHealth CEO William McGuire and several other former UnitedHealth directors and officers agreed to a combination of surrender or relinquishment of stock others and other interests; repayment of certain compensation; and the repricing of other stock option awards, all of which collectively represents a value to the company in excess of $900 million. The value of McGuire’s contribution alone reportedly was valued at more that $600 million.

The sheer magnitude of these values makes this settlement noteworthy. The more interesting question is the extent to which this settlement will affect the resolution of the options backdating cases that remain pending, as well as future shareholders’ derivative lawsuit resolutions.

6. Stoneridge Case Argued: The Tellabs decision was not the only important D & O story out of the Supreme Court this year. On October 9, 2007, the Supreme Court head argument in the Stoneridge v. Scientific Atlanta case. At the time, the case was described as the "business case of the year." How important it will ultimately be remains to be seen, but it could have a very significant impact, as detailed at greater length here.

The case will determine the extent to which a third-party that did not actually make a misrepresentation or misleading statement can be held liable under for securities fraud under Section 10 of the ’34 Act and Rule 10b-5 thereunder. The seemingly likeliest outcome is a narrow holding that does not expand the scope of Section 10(b) liability. The Court’s opinion will be released some time before the end of the current Supreme Court term in June 2008. Until the outcome is known, the possibility (however remote) that the Court might overturn the Eighth Circuit and find an expansive basis for "scheme liability" makes this an important case to watch.

7. Global Warming Disclosure Issues Heat Up: Because global warming is one of the predominant social, political and economic issues of our age, it is almost inevitable that it would be come an important D & O issue as well. As I discuss at length here, the Supreme Court’s April 2007 decision in the Massachusetts v. EPA case provided a new context within which global warming has emerged as a concern for corporate officials. Existing disclosure requirements and activists’ proxy ballot initiatives ensure that this issue will remain as a significant corporate challenge.

Several developments that emerged as the year progressed underscore that global climate change is likely to remain a hot button issue for the foreseeable future, as detailed further here. The first occurred on September 14, 2007, when the New York Attorney General subpoened (refer here) five energy companies demanding that they disclose the financial risks of their greenhouse gas emissions to shareholders. The second is the petition submitted to the SEC by 22 different groups seeking to have the SEC require companies to assess and fully disclose their financial risks from greenhouse gas emissions and global climate change.

The activists’ focus on disclosure issues has serious implications because issues surrounding are at the heart of most D & O claims. Because this issue is likely to grow in importance in coming years, companies may face even greater disclosure pressures and a corresponding increase in liability exposures.

8. Busted Buyouts Beget Litigation: The bursting of the private equity buyout bubble has not only left a raft of busted buyouts in its wake, but has also led to a host of new securities lawsuits. Disappointed target companies that have not become the target of securities class action lawsuits included Radian (about which refer here), Harman Industries (refer here), United Rentals (refer here), and Genesco (refer here). Disappointed target companies that have also lawsuits against their erstwhile acquirers include United Rental’s unsuccessful lawsuits against Cerberus Management Company (refer here) and Genesco’s lawsuit against Finish Line (refer here).

There are a host of other deals that are dead or on life support, as detailed on the M & A Law Prof blog (here). There may be one or more of the companies on this list that may yet find themselves with a securities lawsuit to complement their woes. In any event, the busted deal securities lawsuits collectively represent just one more factor driving the increase in securities lawsuits in 2007.

9. Qwest Opt-Out Settlements Exceed Amount of Class Action Settlement: There have always been opt-outs from securities class action settlements, but during 2007, a number of separate and very substantial opt-out settlements raised potentially important implications for future class action settlements, as well as for D & O insurers’ severity assumptions and policyholders’ views of limits adequacy.

The case with the highest dollar value of publicly reported opt-out settlements is the AOL Time Warner securities litigation, where the nine publicly disclosed opt-out settlements total $795 million, as detailed here. But perhaps even more significant is the Qwest securities litigation, where the $411 million aggregate value of the collective opt-out settlements exceeded the $400 million class action settlements, as further detailed here. When the value of the opt outs settlements tops the value of the class settlement, you know you've got a problem.

The emergence of the opt-out settlements presents a host of potentially complicating problems for current and future securities class action litigants, particularly if significant opt-out settlements become a regular part of securities litigation. These developments could increase litigation expense and aggregate settlement expense in civil securities litigation, and even further complicate efforts to resolve class action lawsuits.

10. Section 11 Settlement Held Not Covered "Loss": Although there had been a prior case holding that a Section 11 settlement is not a covered "loss" under a D & O policy, the prior decision was an intermediate state appellate court decision from Indiana, and was viewed as an anomaly in some quarters. So there was quite a reaction when, on March 14, 2007, Judge Gregory Presnell of the United Stated District Court for the Central District of Florida held (refer here) that the $35 million settlement to which CNL Hotels & Resorts agreed to resolve Section 11 claims does not constitute covered "loss" under a D & O policy and was not insurable as a matter of law.

While at one level, Judge Presnell’s decision was merely an extension of existing case law, it did pose a challenge for the D & O insurance industry to address Section 11 settlement issues in the policy itself. Judge Presnell did specifically note that Section 11 settlements are not "per se" uninsurable. Since the CNL Hotels & Resorts opinion came down, the industry has been scrambling to come up with a policy-based solution, to address policyholder expectations of coverage for Section 11 settlements. The industry is still struggling toward equilibrium on this issue, which remains potentially very important for insured companies and their directors and officers.

Top Top Ten Lists: What could top a top ten list but a list of top top ten lists-- Time Magazine has compled fifty top ten lists for 2007 here.

Updates and Notes

Options Backdating Developments: On December 21, 2007, McAfee announced (here) that it had reached a tentative settlement in the pending federal and state derivative lawsuits related to its options practices. The company said that it "has accrued $13.8 million" that amounts "related to expected payments pursuant to the tentative settlement." The company's press release does not specify to what specific costs this accrual would be applied.

In a separate development, on December 5, 2007, the United States District Court for the Western District of Washington, applying Delaware law, denied the defendants’ motion to dismiss the plaintiffs’ complaint in the derivative lawsuit shareholders have filed against the Getty Images, as nominal defendant, and certain of its directors and officers. A copy of the court’s opinion can be found here. The court found that the plaintiffs’ allegations were sufficient, at least at the pleading stage, to excuse the demand requirement. The Race to the Bottom blog has a detailed discussion of the decision, here.

I have added these case developments in the McAfee and Getty Images cases to my table of options backdating settlements, dismissals and denials. The table can be accessed here.

Cerberus Wins Right to Walk Out on United Rentals: In an earlier post (here) in which I surveyed litigation arising from busted buyouts, I discussed the lawsuit that United Rentals had filed against Cerberus Capital Management, in which United Rentals sought to compel Cerberus to complete the acquisition of United Rentals, from which Cerberus was trying to walk away. The busted United Rentals transaction was somewhat different than other failed deals, in that Cerberus was not claiming that changed circumstances allowed it to renege on the deal; rather Cerberus claimed that the deal documents themselves allowed Cerberus to terminate the contract upon tender of a $100 million termination fee.

In a December 21, 2007 ruling (here), Delaware Chancellor William B. Chandler III, after a two-day trial, issued a 68-page ruling in favor of Cerberus, ruling that Cerberus could abandon the purchase by paying the $100 million breakup fee.

The outcome of the United Rentals lawsuit, while noteworthy, may have only slight influence on the other lawsuits arising from busted deals, because, unlike the erstwhile suitors in those other cases, Cerberus was not relying on the supposed occurrence of "material adverse effect" from a changed circumstance. Rather, the outcome turned on a specific provision of the United Rental agreement that Chancellor Chandler held to reflect an understanding that Cerberus could call of the deal simply by paying the fee.

The M & A Law Prof Blog has a short, interesting post on the decision here. Professor Larry Ribstein also has an interesting discussion of the decision on his Ideoblog, here. The WSJ.com Law Blog comments here on Chancellor Chandler’s language of and use of classical allusions in the decision.

More About Option ARMs: On November 5, 2007, I wrote here about Option ARM mortgages and asked the question whether they represent the next litigation front in the subprime meltdown, referring specifically to the securities lawsuit shareholders had filed against Washington Mutual. The Wall Street Journal asked many of the same questions in a December 22, 2007 article entitled "Option ARM: Next Weakling" (here), noting that Options ARMs "could be the next wave of trouble for the mortgage industry." The article cires a Merrill Lynch report stating that Option ARMs are "ticking time bombs" that will start "ticking louder next year."

Option ARMs give borrowers a choice about how much to pay each month. If borrowers choose to pay only the minimum, the principal amount of their loans can rise – a result known as "negative amortization." Negative amortization would be an unwelcome development at any time, but it is a particular problem when home prices are falling, as they are now. Many option ARMs carried initial teaser rates that are scheduled to reset in the months ahead. According to sources cited in the Journal article, nearly $156 billion in Options ARMs are scheduled to reset between 2008 and the first quarter of 2012. Perhaps worst of all, most Option ARMs carry stiff prepayment penalties, making the loans into a financing form of an existentialist play.
According to the Journal article, both the Colorado and the Illinois attorneys general have subpoenaed mortgage companies as part of larger investigations into Option ARM sales practices.

The option ARMs are not subprime loans; many of the borrowers on these had good credit. But the prospect of potentially significant interest rate increases could raise, perhaps significantly, the level of the payments required to avoid negative amortization. The prospects for further defaults and foreclosures seems high. Merrill Lynch estimates that losses on Option ARMs could top $100 billion. Those losses would be on top of the estimated losses from subprime mortgages of as much as $400 billion.

NERA Releases 2007 Year-End Securities Lawsuit Report

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On December 21, 2007, NERA Economic Consulting released (here) its 2007 Year-End Update analyzing recent trends in shareholder class actions. The NERA reports notes, as I have discussed in prior reports (most recently here), that securities lawsuit filing activity levels returned to historical levels in the second half of 2007. In addition, the NERA report also notes that in 2007 both average and median class action settlements were at all-time highs.

The NERA report’s key findings are as follows:

1. "Despite some well-publicized speculation that filings had moved to a permanently lower level," securities lawsuit filings "increased in 2007 after a marked decline that began in the second half of 205 and continued through 2006."


2. The report states that there were 198 securities lawsuits filed through December 15, 2007, and extrapolates a total of 207 lawsuits through year end, which the report notes would be slightly above the 2005 level but still below the 1998-2004 average annual filing level of 234.


3. The growth in filings was "driven at least in part by litigation related to subprime lending." The NERA report states that there were 38 subprime related securities filings during 2007.


4. The average settlement in 207 was $33.2 million, a jump from $22.7 million in 2006, and well above the 2002-2007 average of $24.4 million. (The averages do not include the nine settlements over $1 billion).


5. In 2007, the annual median settlement also reached an all-time high of $9.6 million, up from $7 million in 2006 and well above the 2002-2007 median of $6.8 million.


6. The most important factor affecting settlements amount is "investor losses"; the median investor loss for cases settled in 2007 was $310 million. The median investor loss in cases filed in 2007 is $355 million, which the Report states is "a signal that the settlements associated with these new filings might remain high."

The NERA report’s conclusions about filing levels are directionally consistent with my prior observations on this blog. I do think it is important to note, as I have detailed elsewhere, that while the subprime-related lawsuits are collectively a significant factor in the increase of filings in the second half of 2007, they are only one among many important factors. More to the point, securities filing activity in the second half of 2007 would still be up significantly over the preceding two years even if there were no subprime cases.

In addition, the NERA report’s lawsuit count is quite a bit higher than my own. My count, which consists of data taken from publicly available sources supplemented by tips I get from readers, show only 171 securities class action lawsuits through December 20, 2007. NERA counts 198 through December 15, 2007 and extrapolates 207 through year-end. I doubt that after today we are going to see too many new lawsuits by year end, so the extrapolated number might be high. It is hard to assess NERA’s count of 198 lawsuits though mid-December, without knowing what cases account for the difference between their tally and mine. I am willing to assume that they just have better data than I do, but I sure would be interesting in knowing what cases I supposedly missed.

Finally, I note that NERA’s count of 38 subprime-related class actions differs from my own count of 34 (refer here for my tally). Part of this difference might be definitional, as it is has become more difficult to sharply describe what is and is not subprime-related. If generalized credit issues cause a company’s problems, is the ensuing lawsuit subprime-related or not? I will say this, I have openly listed the lawsuits I have included on my count here. If NERA or anybody else wants to tell me which cases I have omitted, I will add them to my list with alacrity.

In any event, the NERA report closes with a couple of important points with which I completely agree. First, the report notes that "as the crisis in the credit markets continues to deepen and the market for subprime mortgages continues to suffer accordingly, more litigation is likely to follow." The second is that given the investor losses on the 2007 lawsuits, "the settlements associated with these new filings might remain high."

So here's what the weather gauge says: clouds gathering, storms ahead.

CFO.com has a December 21, 2007 article on the NERA report, here. (Full disclosure, I was intereviewed in connection with the CFO.com article.)

Subprime: The Truth-Telling (and the Lawsuits) Yet to Come

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The various central banks' efforts to improve short-term liquidity in the global financial system have dominated the headlines the business pages in recent days, most recently with respect to the news that the European Central Bank has injected an astonishing $501.7 billion of lending capacity into the banking system, an amount that the Wall Street Journal called "the largest sum the central bank has ever lent in a single shot."

These measures reportedly are calculated to overcome banks’ reluctance to provide each other with short-term loans. What has received less attention is why the banks are reluctant to lend to each other. Closer scrutiny suggests that the banks are wary because they know that many other banks have not yet come clean about the existence of undisclosed losses relating to subprime mortgage problems in the U.S. As one commentator stated in a December 19, 2007 Wall Street Journal article (here),

"Given the degree of uncertainty [and] continuing concerns about where the next losses are and what the next shoe to drop will be, that certainly drives the cautious behavior….It’s a question of grater clarity." That might not come until next spring, when auditors comb through banks’ financial statements in advance of their annual reports. That process "could prove better disclosure and greater clarity to the market. But it might not."

The view that the root cause of the banks’ unwillingness to provide each other short-term credit is based on a perception of undisclosed losses was echoed by the Bank of England governor Mervyn King. In a December 19, 2007 Wall Street Journal article entitled "Bank Losses Still Unclear" (here), King is quoted as saying "We need patience now to get through the period where banks have to disclose the losses they’ve made."

There are several thoughts implicit in these comments. The first is that the banks do in fact have extensive as-yet undisclosed losses. (The banks’ refusal to lend to each other eloquently testifies to the existence of this generalized perception within the banking industry.) The second is that there are banks that will not be disclosing these losses until the banks are compelled to do so by a combination of their reporting obligations and their auditors’ insistence. The overall implication is that these companies have a appointment with truth-telling, scheduled according to their next reporting obligation, presumably to take place sometime in early 2008.

All of this suggests that we should expect a series of bank announcements of losses or significant asset write-downs during the first weeks, perhaps months, of 2008. But the mortgage-backed assets at the center of these losses and write-downs are not held only at banking institutions. Hedge funds, pension funds, insurance companies, mutual funds, REITs and other companies carry these assets as well, and as I have pointed out before (most recently here), this exposure is not limited solely to companies in the financial services sector. There may be a wide variety of companies that have an appointment with truth-telling early in 2008.

Reporting obligations may compel eventual disclosure, but the longer the day of reckoning is delayed, the greater may be the ire of disappointed investors. As I have detailed in my running tally of the subprime-related lawsuits (here), many of the subprime related securities lawsuits have followed dramatic announcements of losses or asset-write downs. With more announcements ahead, further lawsuits seem probable. My depressing assessment is that the worst is yet to come, a conclusion reinforced by the analysis in the following section, below.

Along those lines, it is worth noting that, in connection with the latest big bank write-down announcement – Morgan Stanley’s $9.4 million fourth quarter write-down – that Morgan Stanley employees have already filed a purported class action lawsuit (refer here) on behalf of Morgan Stanley employees in connection with their holdings of company stock in their 401(k) plans.

Why The Losses Will Take Time to Tally: While it is easy to bemoan the truth-telling delay, the reality is that it is going to take time for many of the losses to work their way through the system. These problems are fully illustrated in the December 17, 2007 Wall Street Journal article entitled "CDO Battles: Royal Pain Over Who Gets What" (here), which details the dispute that has arisen as a result of an "event of default" on a single $985 million collateralized debt obligation (CDO) called Sagittarius CDO I Ltd.

Deutsche Bank, the Sagittarius CDO trustee, has filed an interpleader action (view complaint here) to determine whether the CDO’s investors (led in this case by UBS) or the CDO’s credit insurer (a unit of MBIA that entered into a credit default swap) have the right to the remaining payments under the CDO. As the interpleader complaint states, "different Defendants now claim different rights in how the limited fund of Interest Proceeds and Principal Proceeds should be applied." The interpleader complaint names as defendants "Does 1 though 100, the owners of the beneficial interests" – that is the investors who bought the interests in the CDOs. The MBIA unit claims it has senior rights as a result of provisions in the credit default swap agreement, a position that unnamed investors have, according to the complaint, characterized as "neither reasonable nor correct." The interpleader action seeks to sort out the competing interests.

There are several interesting things about this dispute. The first is that it shows that as the mortgage-backed investments deteriorate, there are going to be disputes over who gets stuck with the losses or at least who gets which proportion of the losses. The second is that the Sagittarius "event of default" is not an isolated occurrence; according to the Journal article, "about 40 consumer-debt backed CDOs have declared an event of default; their face value is near $45 billion – about 7% of the $640 billion in the CDOs outstanding rated by Moody’s." Indeed, three CDOs have started liquidation, and JP Morgan projects that by the second quarter, "$40 billion to $50 billion in subprime-mortgage bonds could be sold by distressed CDOs that decide to liquidate."

The final thing to note about this dispute is who is identified as facing the losses. According to the Journal article, the UBS investors in the Sagittarius CDO are two UBS mutual funds – the UBS Absolute Return Bond Fund and the UBS Global Bond Fund – which bought $1.2 million of the CDO this year. As I noted above, the deteriorating market for asset-backed securities could impact a wide variety of investors, funds and companies. It may take a while for the losses to sort themselves out, but eventually the losses will hit home.

The investors who get hit with these losses are unlikely to take these losses quietly. In addition, many CDO investors (such as hedge funds, pension funds, and mutual funds) in turn have investors of their own that will upset about the fund losses. I have previously noted (here) that there has already been one securities class action lawsuit brought involving subprime-related losses in a mutual bond fund.

The lawsuits against these investment funds may well come from a variety of directions, as illustrated by the action that Barclays filed on December 19, 2007 against the Bear Stearns companies in connection with the subprime-related collapse of two Bear Stearns hedge funds. Barclays was not an investor in the collapsed funds, at least not in the conventional sense; it was rather in the position of lender, supplying borrowed capital, Barclays claims, based on misrepresentation, as part of a complex hedged counterparty relationship. The complaint alleges that Bear Stearns misled Barclays about the nature of the funds' investments as well as about the condition of the funds as they deteriorated. A December 19, 2007 Wall Street Journal article describing the Barclays suit can be found here. A copy of the Barclays complaint can be found here.

Lawsuits are also likely to follow against the entities that sold the CDO investments in the first place. For example, the Financial Times reports in a December 17, 2007 article entitled "Lehman Faces Australian Lawsuit Threat Over High-Risk Debt Deals" (here), Lehman Brothers faces the threat of legal action by three Australian municipal councils over the sale of CDOs by Lehman’s local subsidiary. The CDOs in which the municipal councils invested are in some cases now marked down to as low as 16 cents on the dollar.

All of which, I think, underscores the point that the losses and lawsuits yet to come will be widespread. The title of this December 19, 2007 Financial Week article (here) says it all: "Lawsuits Linked to Subprime Damage Expected Next Year." As the article notes, "the other litigation shoe to drop in the CDO implosion will involve legal claims against banks and hedge funds by institutional investors, including other hedge funds and pension funds."

Hat tip to the WSJ.com Law Blog (here) for the link to the Deutsche Bank interpleader complaint.

Subprime Litigation Wave Hits Huntington Bancshares: According to a December 19, 2007 press release (here), shareholders have initiated a subprime-related securities class action lawsuit against Huntington Bancshares Incorporated in the United States District Court for the Southern District of Ohio. A copy of the complaint can be found here.

According to the press release, the complaint alleges that

Huntington had acquired more than $1.5 billion in exposure to subprime mortgages with its July 2007 acquisition of Sky Financial Group, Inc. ("Sky Financial"). As the real estate and credit markets continued to soften, defendants repeatedly assured Huntington investors that the Company had undertaken significant preparations and implemented defensive measures to weather the deteriorating real estate and credit markets. By the time Huntington closed the merger with Sky Financial, the housing and credit crisis had deepened, yet defendants continued to conceal Huntington’s growing exposure to these problems so as to not acknowledge the acquisition was a debacle so soon after it closed. As a result of defendants’ false statements, Huntington stock traded at an artificially inflated price of approximately $18 per share during much of the Class Period.

Then, on November 16, 2007, Huntington announced its fourth quarter 2007 financial results, stating that as a result of the recently announced actions of Franklin Credit Management Corporation, which had a commercial lending relationship with Sky Financial, and related deterioration in Franklin’s mortgage portfolios, 2007 fourth quarter results for Huntington were expected to include an after-tax charge of up to $300 million, or $0.81 per common share. As a result of this charge, Huntington would report a 2007 fourth quarter net loss.

On this news, Huntington’s stock dropped from $16.08 per share to as low as $14.38 per share, closing at $14.75 per share on November 16, 2007 on volume of over 10 million shares.

I have added the Huntington Bancshares lawsuit to my running tally of subprime-related securities lawsuits, which can be found here. The addition of the Huntington case brings the number of subprime-related lawsuits to 27, not counting the five subprime related securities lawsuits that have been brought against home builders, and the two that have been brought against the credit rating agencies. Adding these categories together brings the total number of subprime-related securities lawsuits to 34. The addition of the list of Morgan Stanley 401(k) lawsuit cited above brings the total number of subprime-related ERISA/401(k) lawsuits to 6.

Another Securities Class Settlement Complication: Government Intervention

In recent posts (most recently here), I have discussed the potential difficulties that opt-out actions may present for securities class settlements. As if that were not complication enough, now the government wants to get into the act. As discussed below, the Department of Justice has appeared to object to the pending settlement of the consolidated class action securities lawsuit and derivative litigation involving DHB Industries (known since October 2. 2007 as Point Blank Solutions). The government’s appearance in the case raise some interesting questions.

The securities lawsuit and the shareholder derivative litigation first arose in September 2005, when shareholders sued the company and certain of its directors and officers. Refer here for background regarding the litigation. The shareholders’ amended complaint alleged that the individual defendants inflated the company’s share value then sold substantially all their shares, shortly prior to the company’s announcement of law enforcement officials’ concerns regarding the protective value of the company’s bullet proof vests and of certain issues regarding the company’s financials. The company ultimately withdrew reliance on its financial statements for 2003, 2004 and the first nine months of 2005.

On July 13, 2006, the company announced (here) a joint settlement of the securities lawsuit and the derivative litigation. According to the company’s announcement, the settlement consisted of the company’s agreement to pay $34.9 million in cash, plus 3,184,713 shares of company stock. The derivative case was settled in consideration of the company’s agreement to adopt corporate governance reforms and pay $300,000 of the derivative plaintiffs’ counsel’s fees. $12.9 million of the cash payment is to be paid by the company’s insurers. In addition, the company’s founder, Chairman and CEO, David Brooks, agreed to resign from all positions he held.

The company itself lacked cash to fund the portion of the cash settlement in excess of the insurance. To fund the settlement, the company entered into a transaction with Brooks whereby he would received nonregistered company shares in exchange for cash the company could use to fund the settlement. In return for his agreement to provide financing sufficient to fund the settlement, Brooks required that the company release him from any claims the company might have arising from his conduct as an officer of the company.

The court has held a series of hearings to consider final approval of the settlement, but the settlement has not yet been finally approved.

In a separate but related development, on October 25, 2007, the U.S. Attorney’s Office for the Eastern District of New York filed a superseding criminal indictment (here) charging Brooks and the company’s former Chief Operating Officer with insider trading, fraud, obstruction of justice, and tax evasion. As described here, the indictment alleges that the two officials inflated the company’s stock price by manipulating its financial records to increase earnings, including fraudulent accounts of armor inventory. The two were also charged with cutting themselves company checks for personal gain. Among the personal expenses Brooks is alleged to have charged to the company are $16,000 for a photographer for his son’s Bar Mitzvah and $101,190 for a "belt buckle studded with diamonds, rubies and sapphires." A scathing commentary on the indictment and the company’s allegedly unsatisfactory role in the provision of body armor to U.S. troops in Iraq can be found here. His daughter's Bat Mizvah, which allegedly cost $10 million, has also drawn, well, interesting commentary on the Internet.

At the same time as prosecutors commenced the criminal action, the SEC also initiated a civil enforcement action against Brooks (refer here). Among other things, the SEC complaint alleges that Brooks sold $186 million of his personal holdings of DHB stock while in the possession of material nonpublic information. Among other things, the SEC complaint seeks reimbursement by Brooks to DHB of bonuses and profits from stock sales pursuant to Section 304 (the so-called "clawback" provision) of the Sarbanes-Oxley Act.

These developments in the criminal proceeding and the SEC enforcement action became relevant to the securities lawsuit and the derivative lawsuit on November 19, 2007, when the Department of Justice filed its objections to the pending shareholder litigation settlement (here).
The government’s objections to the pending settlement are two-fold: first that the criminal defendants might try to use their release in the proposed settlement "to avoid their obligation, if convicted, to make full restitution." Second, the government also objects on the ground that the proposed settlement release document purports to release the defendants from Section 304 liability, and to indemnify them for any third party Section 304 claim or settlement.

With respect to the release potentially absolving the defendants of their potential restitution obligation, the government asks for the "addition of a specific provision to the proposed settlement agreement providing that ‘nothing contained in this settlement is intended to limit the United States’ ability to pursue forfeiture, restitution or fines in any criminal, civil or administrative proceeding.’"

With respect to the government’s objections relating to Section 304, the government notes that to allow the defendants to be released and indemnified by the company "would undermine the very purpose behind Congress’ enactment of section 304." The government "asks the Court not to approve the settlement unless this provision is removed."

But the government did not stop there. Having had its say about the parts of the settlement that affect the interests of the United States, the government then went on to express its views about other aspects the settlement. As the government put it, "there are several other aspects of the proposed settlement that may warrant specific attention." In explaining its provision of these additional comments, the government added that it "takes no position" on "whether these aspects of the proposed settlement should preclude a finding that the proposed settlement is fair, adequate and reasonable."

The government’s extra two cents worth consists of the observation first that "the majority of the Defendants in these actions are [sic] not paying any consideration towards the settlement, but are nonetheless receiving broad releases." The second is that, because the company’s share price has risen since the settlement was first proposed, the value of the shares Brooks purchased to fund the settlement have appreciated, as a result of which Brooks could "earn a profit of approximately $10 million on those shares, thus reducing his out-of-pocket contribution to the settlement." Accordingly, the government notes "the Court may therefore want to assess whether Brooks’ contribution to the settlement is appropriate."

The government is of course not a party to the private securities lawsuit. The bases on which the government made its appearance are under the Class Action Fairness Act of 2005 (pursuant to which the Attorney General must be given notice of class settlement) and 28 U.S.C. Section 517 (which gives the Attorney General the right to send an officer "to attend to the interests of the United States in a suit pending in a court of the United States.")

While the U.S. government uses its Section 517 authority to appear in a wide variety of cases (refer, for example, here and here), I am not familiar with the government using this authority to intervene in a private securities class action to object to its settlement --I welcome others' comments if this is more common than I am aware. In any event, it may be that the government resorted to this approach due to the fact that the case settlement preceded the indictment, as a result of which the government was unable to arrange the kind of collaborative settlement, for example, recently announced in connection with the UnitedHealth Group options backdating derivative settlement and SEC settlement.

But the troublesome thing about the government’s objection in the DHB Industries case is that having made its appearance, the government took the liberty of providing its own commentary on the merits of other aspects of the settlement. Section 517 may give the government authority to "attend to the interests of the United States" in pending lawsuits, but even under Section 517, the government's role is limited to "attending" to the interests of the United States.

Whatever else anybody might want to say about these circumstances, the parties to the lawsuit have the right to negotiate their interests, without concerns of the government providing potentially obtrusive supervision. The class members are fully and appropriately represented under class action procedures, subject to the court's review. Individual class members retain all of their rights to object to the proposed settlement and in fact some members of the class in fact have done so. What right does the government have to criticize elements of the settlement beyond the government’s interests?

The government’s actions undoubtedly are a reflection of the unique circumstances surrounding the case. But the prospect of the government acting as a kibitzer on class settlements is a concern. The terrain surrounding private securities class action litigation is already challenging enough without the government getting into the act.

Special thanks to Bill Baker of Latham & Watkins for sending along a copy of the government’s objections.

Securities Litigation Filing Trends: In recent posts (most recently here), I have noted that during the second-half of 2007, securities lawsuit filing levels have returned to historical norms after a tw0-year lull. In the most recent issue of InSights, entitled "The Two-Year Lull is Over: Securities Lawsuit Filings Rise" (here), I detail the recent increase in securities lawsuits filing activity and comment on the potential significance of these changes for the D&O insurance marketplace.

Blog Watch: The D & O Diary has recently been reading with interest the postings on the new blog PomTalk (here), a blog on corporate and securities law issues of interest to institutional investors produced by the Pomerantz Haudek Block Grossman & Gross law firm. The blog looks like a worthy addition to the blogosphere, and we look forward to reading future PomTalk posts.
Oil in Hell: Those struggling to understand how so many of the big investment banks have gotten burned so badly on their own holdings in subprime mortgage-backed securities may gain some insight from this excerpt, taken from the Chairman's Letter in the 1985 Berkshire-Hathaway Annual Report:

You might think that institutions, with their large staffs of highly-paid and experienced investment professionals, would be a force for stability and reason in financial markets. They are not .... Ben Graham told a story 40 years ago that illustrates why investment professionals behave as they do: An oil prospector, moving to his heavenly reward, was met by St. Peter with bad news. “You’re qualified for residence," said St. Peter, “but, as you can see, the compound reserved for oil men is packed. There’s no way to squeeze you in.” After thinking a moment, the prospector asked if he might say just four words to the present occupants. That seemed harmless to St. Peter, so the prospector cupped his hands and yelled, “Oil discovered in hell.” Immediately the gate to the compound opened and all of the oil men marched out to head for the nether regions. Impressed, St. Peter invited the prospector to move in and make himself comfortable. The prospector paused. “No,” he said, “I think I’ll go along with the rest of the boys. There might be some truth to that rumor after all.”

Subprime Litigation Wave Hits UBS – and Other Web Notes

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In a prior post (here), I compared the similarity of the piecemeal way that UBS, Merrill Lynch and Citibank have disclosed their subprime-related asset valuation write-downs. Now UBS has one more thing in common with the other two banks – it has been named as a defendant in a securities class action lawsuit.

According to the plaintiff’s counsel’s December 13, 2007 press release (here), the plaintiffs initiated a securities lawsuits in the Southern District of New York against UBS AG and certain of its directors and officers. A copy of the complaint can be found here. According to the press release, the complaint alleges that

On October 30, 2007, UBS issued a press release announcing its financial results for the third quarter of 2007. In the days following this announcement, the price of UBS stock declined to as low as $49.27 per share. Then, on December 10, 2007, UBS announced writedowns of around $10 billion as a result of its subprime mortgage related positions. Following this announcement, the price of UBS stock declined to $48.78 per share, a 26% decline from the Class Period high. The action purports to be brought on behalf of all shareholders who purchased UBS stock between March 13, 2007 and December 11, 2007.

The complaint quotes at length from an October 12, 2007 Wall Street Journal article entitled "U.S. Investors Face An Age of Murky Pricing" (here) which discusses at length how in March 2007, a hedge-fund unit of UBS (Dillon Read) was slashing its valuations on subprime-related assets at a time when UBS was carrying similar assets at much higher valuations. The article describes tense communications between UBS bankers and the Dillon Read trader, in which they questioned where he was coming up with his valuations, and he questioned the bankers’ valuations at higher levels that he felt were unavailable in the marketplace. UBS closed the hedge fund this summer, but it also did later write down its assets to lower valuations, and more recently to much lower valuations. (I commend this article if you have not yet read it; I re-read it for purposes of writing this blog post and even though it is only two months old it already provides some interesting and useful perspective.)

In addition to the securities class action, according to a separate December 13, 2007 press release (here), separate plaintiffs’ counsel have filed a separate lawsuit in the Southern District of New York, raising similar allegations, on behalf of UBS employees who suffered losses as purchasers of their employers stock in their 401(k) plans.

As I discussed at greater length in my prior post (here), the pattern of piecemeal disclosure of subprime-related losses is one factor contributing to the subprime litigation wave. Unfortunately, the difficulties that many companies are having in valuing assets in a deteriorating environment contributes to this disclosure pattern, and potentially to further subprime-related litigation.

I have added the new UBS lawsuits to my running tally of subprime related litigation (here). With the addition of the UBS action, the current tally of subprime related securities class action lawsuits now stands at 26, not counting the four subprime-related securities lawsuits that have been filed against residential home construction companies and the two subprime-related securities lawsuits that have been filed against the rating agencies. These categories taken together add up to 32 subprime-related securities lawsuits. In addition, the UBS 401(k) lawsuit brings the total of subprime-related ERISA/401(k) lawsuits to five.

Options Backdating-Related Securities Settlement: On December 13, 2007, American Tower announced (here) that it has reached a settlement in principle of the consolidated options backdating-related securities class action lawsuits that had been filed against the company and certain of its directors and officers. Refer here for background regarding the lawsuit. In connection with the settlement, the company will make a $14 million cash payment. The company stated that "it has been and will continue to be in discussions with its insurers concerning the amount of their contribution to the settlement."

I have added the American Tower settlement to my cumulative table of options backdating-related lawsuit settlements, dismissals, and denials. The table can be accessed here.

Another Target for Subprime Ire: The list of purported scapegoats for the subprime crisis is already lengthy, but a December 13, 2007 Washington Post article entitled "Analysts Late to the Alarm" (here) adds yet another new category of targets to blame. The article notes that securities analysts "did not sound the alarm on the subprime mess," but asks whether "analysis [should] have seen the meltdown coming?"

The article observes that while there have been much "finger-pointing" at the analysts, there has as yet been "no conclusion." Among other things, the complexity of the financial instruments involved and the multifaceted nature of the credit issues eluded all but a few analysts. Other contributing factors for the analysis included "the pressure to always be right, the difficulty of going against the tide, and the need to hang onto clients." The article also examines, without expressing views, whether conflicts of interests could have played a role.

Why the JDS Uniphase Securities Suit Went to Trial: Law.com has a December 13, 2007 article entitled "In-House Lawyers Go for All or Nothing in Securities Case" (here), which gives an inside look at why the JDS Uniphase case went to trial (for background about the trial refer here). The article examines the process that led up to the decision to take the case to trial and the barriers that prevented settlement. The article also gives a look at the pressure the company’s in-house counsel faced as a result of the decision to take the case to trial.

The lawyers involved in this case clearly deserve credit for courage and perseverance. But after reading the account of what they went through, it is hard to imagine may others being willing to make the same decision and to face that kind of pressure. The JDS Uniphase verdict theoretically might embolden others to push a case to trial, but the reality is that very few would be willing to undertake the risk and the pressure.

Subprime Disclosures and Accounting

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Among the more disconcerting aspects of the unfolding subprime crisis has been the unseemly spectacle of major financial institutions taking dramatically increased asset value write-downs shortly after having disclosed smaller write-downs on the same assets. UBS became the latest company to follow this pattern earlier this week when it announced (refer here) an increased $10 billion asset write-down, only three weeks after taking a $4.4 billion write-down in connection with the same assets. UBS’s increased write down following the more or less same sequence of events as were involved with write-down disclosures at Merrill Lynch (about which refer here) and Citigroup (about which refer here).

In its December 10, 2007 press release explaining its most recent write-downs (here), UBS said it was making its move “in response to continued deterioration in the U.S. subprime securities market,” as a result of which, the company “revised assumptions and inputs used to value U.S. subprime mortgage related positions.”

Perhaps due to the deterioration in the market for U.S. mortgage-backed securities, but also likely in response to the undesirability of the pattern of piecemeal asset valuation disclosures, SEC Chairman Christopher Cox reportedly said on December 10, 2007 (refer here) that the SEC will be sending letters to approximately two dozen financial service firms, including banks and insurance firms, urging them to disclose “more information about their exposure to potentially problematic loans in light of the massive number of gargantuan write-offs caused by the subprime lending crisis.”

Underlying these developments is the fundamental difficulty companies are facing in valuing many of these mortgage-backed assets. The asset valuation difficulty is apparently of particular concern to the Public Company Accounting Oversight Board (PCAOB), which on December 10, 2007 released an Audit Practice Alert entitled “Matters Related to Auditing Fair Value Measurements of Financial Instruments and the Use of Specialists” (here). The Alert is written in light of the circumstances that may “make it difficult to obtain relevant market information to estimate the fair value of many mortgage-backed securities,” which is likely to “increase audit risk.”

The Alert’s purpose is to draw auditors’ attention to certain areas of the new fair value accounting standards under SFAS No. 157, which is effective for financial statements issued for fiscal years beginning after November 15, 2007, and for interim periods within those fiscal years. In other words, these new standards are about to start applying to many companies for the first time in the reporting period that is currently underway. The PCAOB is clearly worried that there may be problems as the new fair value standards are applied to many mortgage-backed securities.

According to a December 11, 2007 CFO.com article (here), the PCAOB issued the Alert “over concerns that the subprime mortgage crisis will increase the volume of fair value recalculations companies will be forced to make after accounting for losses from the subprime collapse.” At the heart of the Alert is a discussion of the hierarchy of inputs to be used in determining whether a company’s financial statement disclosures are complete, accurate and in compliance with GAAP.
Under SFAS No. 157, as the reliability of the inputs decreases, the company’s disclosure obligations increase. (UBS’s recent increased write-down is in effect a practical example of these principles in action, as the company said that its increased write-down was the result of the results derived from changing the inputs used in its asset valuation.) The Alert observes that this hierarchy creates some obvious, potentially unhealthy incentives: “Because there are different consequences associated with each of the three levels of hierarchy, the auditor should be alert for circumstances in which the company may have an incentive to inappropriately classify fair value measurements within the hierarchy.”

The PCAOB’s encouragement for auditor attentiveness to these issues clearly reflects a concern that in order to avoid certain adverse disclosures, some companies may not come clean. The PCAOB’s alert is obviously intended to ensure that auditors are fully engaged in their critical audit function in assessing the valuations companies assign to mortgage-backed assets. While time will tell how these changing standards and audit processes will play out, the Alert implicitly assumes that auditors may be forced to challenge their clients’ valuation assumptions, which in turn could lead to additional financial statement disclosures (and, potentially, asset valuation write-downs).

These accounting issues not only directly affect financial statement disclosure issues, but they may also be at the heart of future subprime related litigation. Many of the subprime-related lawsuits that have already arisen are built around accounting-related allegations, including, for example, the adequacy of loan loss reserves; the failure to properly account for the allowance for loan repurchase losses; and the failure to properly account for the residual interests in securitizations. But more to the point for purposes of this blog post, many of the subprime-related lawsuits have contained allegations related to the failure to timely write down impaired assets. An excellent, detailed discussion of the accounting issues that have arisen in subprime-related litigation can be found in NERA Economic Consulting’s December 6, 2007 publication “The Subprime Meltdown: Understanding Accounting-Related Allegations” (here).

The piecemeal process by which many companies have disclosed their valuation write-downs on mortgage-backed assets has already engendered litigation. The PCAOB’s alert suggests that it is concerned that in connection with their implementation of SFAS No. 157, auditors may also be called upon to reassess asset valuations, a process that could lead to further disclosure and even write-offs. These circumstances certainly present the possibility for even further subprime-related litigation following adjusted asset valuation disclosures.

One final note is probably worth emphasizing. As I have previously discussed at greater length (here), these asset valuation problems are not restricted to the financial sector. The mortgage-backed assets at the center of these valuations are broadly dispersed in the economy and can found on the balance sheets of a wide variety of entities. The potential exists for the asset valuation issues discussed above to affect some unexpected companies, which, in turn, could further spread the growing subprime litigation wave.

The December 12, 2007 Wall Street Journal has an article entitled "A Subprime Gauge, in Many Ways?" (here), discussing problems that many companies (including, for example, UBS) are having with one of the inputs that might be used in subprime-mortgage backed asset valuations, the ABX index, which tracks the value of securities backed by subprime home loans. The article underscores the difficulties that companies are having in determining the approriate asset valuation inputs.

Mortgage Professionals’ Litigation Exposure: As this blog has noted before (most recently here), the subprime-related litigation wave is likely to hit a wide variety of professionals. Among the professionals that have already become involved in subprime-related litigation have been those in the real estate industry (as discussed here). According to a December 2007 report (here) prepared by reinsurance broker Guy Carpenter, real estate professionals’ susceptibility to litigation may vary by state, depending on a set of possible variables.

According to the report, real estate professionals “may have more cause to worry depending on the states in which they practice,” according to the “convergence of a variety of legal and business conditions” that “create an overall climate of risk.” The report ranks the various states based on an index of factors (such as the percentage of mortgages in foreclosure, the number of litigation attorneys, and the frequency of Truth in Lending lawsuits). States ranked as having a high risk of mortgage professional litigation according to this index includes Alabama, Connecticut, Georgia, and Illinois. The lowest ranking states include Wyoming, Vermont, South Dakota and Oregon.

Chinese IPOs: Discuss

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Chinese companies’ listing debuts are a vital force in the current global IPO marketplace. According to a December 8, 2007 Wall Street Journal chart (here), 195 Chinese companies listed their shares through November, raising $87.3 billion – representing a 26.7% share of the 2007 global IPO volume. By contrast, the IPOs of 174 U.S. domiciled companies raised $38.5 billion, which represents an 11.8% share. In addition, according to a December 3, 2007 Wall Street Journal article entitled "Chinese Firms Will Test Market Appetite for IPOs" (here), "December could see the launch of three issues that, in total, might eventually raise more than $12 billion." By years’ end, the amount raised in 2007 by Chinese company IPOs could well exceed $100 billion.

Stock exchanges around the world are jockeying for a piece of this action. A December 3, 2007 Financial Times article entitled "Markets Jostle to be China’s IPO Buddy" (here) notes that "Singapore and Hong Kong are falling all over themselves to be the destination of choice for capital hungry mainland companies, while smaller Chinese companies are still attracted to the perceived lighter-touch regulation of London’s Alternative Investment Market." By the same token, the three anticipated December offerings mentioned above are all scheduled to take place in Hong Kong or Shanghai – not in New York.

In order to try to increase its share of this business, on December 3, Nasdaq opened a Beijing office. The Financial Times article, commenting on the office opening, snipes that the U.S. exchanges "face steep challenges, including the time zone and worries about the country’s litigious environment." (More about what the litigious environment has meant for Chinese companies below.) But the biggest challenge for the U.S. exchanges is that "Asia is so awash with liquidity that issuers rarely need to look beyond Hong Kong."

For all that, in 2007, Nasdaq still managed to increase the number of its Chinese listings. According to a December 3, 2007 Wall Street Journal article about the Nasdaq Beijing office opening (here), as of the end of November Nasdaq had 52 listed mainland Chinese companies, with a combined market capitalization of $57 billion, up from 33 Chinese firms with a total capitalization of $25 billion at the end of 2006. The 19 listings by Chinese companies this year are "more than double last year’s total of nine."

Give the ample liquidity available in Asian financial markets, it is worth asking why Chinese companies would nevertheless be willing to confront U.S regulatory requirements, litigiousness, and time zone differences to list their shares in New York. According to a May 10, 2007 Financial Times article entitled "New York Proves an Attractive Destination" (here), the large privatized Chinese enterprises are attracted to Hong Kong, but maturing small venture-capital backed companies are attracted to New York because "they can still get better valuations and wider analyst coverage in [the high tech and life sciences] sectors than in the resurgent Chinese domestic markets or in the other parts of the world.’ One source is quoted in the article as saying that a New York listing helps the companies to establish their brand internationally, for which "nothing matches a U.S. listing."

But before we break out the champagne to celebrate Nasdaq’s success in attracting more Chinese companies’ offerings in 2007, it is worth taking a look at what the increased number of Chinese listings has actually wrought. Even a quick look suggests that just because a Chinese company is eager to list its shares does not necessarily mean that the company is ready for the scrutiny that comes with a U.S. listing. Indeed, a more detailed analysis confirms that some of the Chinese companies that have listed their shares on U.S. exchanges may not have been ready for the burdens and responsibilities, to their investors’ disappointment.

The most telling fact is that of the roughly 165 companies that have been sued in securities class action lawsuits in 2007, seven are Chinese companies. Even more significantly, of those seven companies, five completed their IPOs less than 12 months prior to the initial lawsuit filing – including one, Giant Interactive, that debuted on November 1, 2007 and was first sued on November 26. A sixth company, Focus Media Holdings, which was first sued on November 27, 2007, had just completed a secondary offering on November 7, 2007.

A review of the allegations of the lawsuits against the seven companies reinforces the view that at least some of these Chinese companies that the U.S exchanges succeeded in attracting to New York may not have been ready for prime time.

Here is a brief summary of the allegations against the seven companies:

Xinhua Finance Media (first sued on May 22, 2007, refer here): The plaintiffs allege that the Prospectus issued in connection with the company’s March 8, 2007 IPO failed to disclose that the company’s CFO at the time of the offering was simultaneously an investment banker in charge of a securities firm that is the subject of an SEC investigation, and that he was also an investor in two companies that had been sued by the SEC for fraud.

Qiao Xing Universal Telephone (first sued on August 9, 2007, refer here): The lawsuit arises out of the company’s restatement of its financials for the years 2003, 2004 and 2005. The company stated at the time that misstatements resulted from deficiencies in the company’s internal controls over financial reporting.

China Sunergy Company Limited (first sued on September 10, 2007, refer here): The lawsuit alleges that the company’s Prospectus in connection with its May 17, 2007 IPO failed to disclose that the company was having difficulty obtaining a sufficient supply of polysilicon, which forseeably would have a near-term impact on earnings.

LDK Solar Company (first sued on October 9, 2007, refer here): The company was sued after the company’s financial controller resigned, reporting to the SEC and the company’s external auditor that the company lacked internal controls and that the company’s reported polysilicon inventory was 25% overstated.

Fuwei Film (Holdings) Company (first sued on November 19, 2007, refer here): The lawsuit alleges that the Prospectus in connection with the company’s December 19, 2006 offering failed to disclose that the company’s main operating assets were obtained through transactions that may not have been valid under Chinese law. On October 15, 2007, three of the company’s major shareholders, including one director, were arrested on suspicion of legal violations.

Giant Interactive Group (first sued on November 26, 2007, refer here): The lawsuit alleges that the Prospectus released in connection with the company’s November 1, 2007 IPO failed to disclose that the company had experienced a third-quarter 2007 decline in users (i.e., prior to the offering), which it disclosed for the first time on November 19 (less than 3 weeks after the offering).

Focus Media Holding (first sued on November 27, 2007, refer here): The lawsuit alleges that the company’s Prospectus in connection with its November 7, 2007 secondary offering failed to disclose that acquisitions in its Internet advertising division were depressing the division’s gross margins. In the company’s November 19 earning release, it disclosed that its gross margins had declined due to several recent acquisitions.

To be sure, there is nothing uniquely Chinese about these kinds of allegations (except perhaps with respect to the Fuwei Film allegations). But it is the frequency of these allegations relative to the number of listings that is disturbing. Five of these seven companies are listed on Nasdaq (LDK Solar and Giant Interactive are NYSE listed), meaning that these five represent roughly ten percent of the 52 Nasdaq listed Chinese companies. Moreover, four of the seven are among the 19 Chinese companies that debuted on Nasdaq in 2007 – representing roughly 21% of all Chinese companies that listed on Nasdaq this year.

If the U.S. exchanges' "success" means only that they have attracted companies that stumble out of the blocks, investors may soon lose their sinophilia. This process may already be taking place. A December 7, 2007 Wall Street Journal article entitled "China IPOs Lose Some Allure" (here) noted that two Chinese companies, WSP Holding and VisionChina Media, had to cut their prices to sell shares in their December 6 offerings.

All of this could be interpreted to suggest that in the U.S exchanges’ haste to woo Chinese listings, they may be attracting companies that are not prepared for everything that goes with a U.S. listing. U.S toy retailers learned the hard way that consumers expect to be protected from toys with lead-based paint. The U.S exchanges shouldn’t have to learn this same lesson all over again in the financial marketplace. The measure of the U.S exchanges’ "success" in the global IPO marketplace should not be based on quantity, but on quality, in order for the U.S markets to maintain their reputation for transparency and integrity and to continue to offer superior valuations for companies that can, in fact, withstand the scrutiny. For the sake of the competitiveness of the U.S financial markets, the U.S exchanges themselves must take steps to ensure that foreign issuers continue to perceive that "nothing matches a U.S. listing."