Sunday, January 06, 2008

Subprime Litigation Wave Hits State Street

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On January 3, 2008, State Street Corporation announced (here) that for the fourth quarter of 2007, it will be establishing a reserve of $618 million, on a pre-tax basis, "to address legal exposure and other costs associated with the underperformance of … fixed-income strategies managed by… the company’s investment management arm." The net charge to the company, "after taking into account the tax effect of the reserve and associated lower incentive compensation cost" will be $279 million.

In its January 3 press release, the company did not identify the specific litigation to which the reserve will relate; rather, the company referenced only "customer concerns as to whether the execution of [the fixed-income strategies] was consistent with the customers’ investment intent." The press release goes on to state that the strategies "were adversely impacted by exposure to, and the lack of liquidity in, subprime mortgage markets."

A January 4, 2007 New York Times article entitled "State Street Corp. Is Sued Over Pension Losses" (here) states that State Street decided to create the reserve "after five clients sued it, claiming they had lost tens of millions of dollars in State Street funds they were told would be invested in risk-free debt like Treasuries." The Times article briefly identifies four of the claimants, but adds that "it was unclear who brought the fifth suit."

Because of the possibility that, as stated in the Times article, that State Street’s litigation and related reserve "highlight the legal challenges that lie ahead for financial firms," it would appear to be worthwhile to review here the five State Street lawsuits. The value of this exercise is underscored by the perception (which I share) voiced by one commentator quoted in the Times article that "there could be many, many more" lawsuits like those against State Street.

The first of the five lawsuits was brought on October 1, 2007 by Prudential Retirement Insurance and Annuity Company. (I previously posted about the Prudential lawsuit here.) A copy of the Prudential complaint can be found here. According to Prudential Financial’s October 1, 2007 filing on Form 8-K (here), the action "seeks, among other relief, restitution of certain losses attributable to certain investment funds" sold by State Street’s investment management arm, and alleges that State Street "failed to exercise prudent investment management." The specific legal basis of Prudential’s claim is that State Street and its investment arm violated the Employee Retirement Income Security Act of 1974 (ERISA).

The complaint alleges that the defendants "radically altered" the investment strategies of two bond funds, the Intermediate Bond Fund and the Government Credit Bond Fund. The complaint alleges that the funds "took undisclosed, highly leveraged positions in mortgage-related financial derivatives" and thereby "exposed" the funds to "an inappropriate level of risk" that during the summer of 2007 "produced catastrophic results." The complaint further alleges that as these events unfolded the defendants provided "untimely, incomplete and misleading information."

The Prudential complaint alleges that the defendants caused losses of "roughly $80 million" to assets held by about 165 retirement plans for which Prudential is responsible, affecting approximately 28,000 plan participants. The complaint seeks restitution and compensation for the investor losses (which Prudential has, according to an October 2, 2007 Wall Street Journal article, here, already reimbursed). The complaint also seeks recovery of fees and other amounts the defendants’ received, as well as recovery of the plaintiff’s attorneys’ fees.

Of the five lawsuits against State Street in connection with which the company established its litigation reserve, three others (in addition to the Prudential lawsuit) allege violations of ERISA. The first of these three other ERISA lawsuits was brought on October 17, 2007 by Unisystems and the trustee of the Unisystems Employees’ Profit Sharing Plan. A copy of the Unisystems amended complaint can be found here. (My prior post about the Unisystems complaint can be found here.)

The second of the three other ERISA lawsuits was brought on October 24, 2007 by the Composite Pension Trust of Nashua Corporation. A copy of the Nashua complaint can be found here.

The third of the three other ERISA lawsuits (and the fourth of the five total lawsuits brought against State Street) was brought on October 31, 2007 by the plan administrator and the trustee of the Employees’ Savings and Profit Sharing Plan of the Andover Companies. A copy of the amended Andover Complaint can be found here.

The fifth of the five lawsuits against State Street (which is also the lawsuit which the Times was unable to identify) was brought on November 5, 2007 in Harris County, Texas, District Court by Memorial Hermann Healthcare System. On December 3, 2007, the defendants removed the Memorial Hermann complaint to the Southern District of Texas. A copy of the removal petition, to which the initial state court complaint is attached, can be found here. Unlike the four other State Street lawsuits, the Memorial Hermann complaint does not allege a violation of ERISA. Instead, the complaint asserts against the State Street defendants a variety of state law claims, including breach of contract, fraud and negligent misrepresentation.

The Memorial Hermann complaint essentially alleges that the State Street defendants breached an "Agreement of Trust" to serve as trustee of nearly $91 million in the plaintiff’s assets. The assets allegedly were invested in the State Street Limited Duration Bond Fund, which the complaint alleges lost 37 percent of its value during three weeks in August 2007, and 42 percent of its value for the 2007 year. The losses allegedly were the result of "unjustified investments in mortgage securities without diversification and using derivatives, all contrary to the stated Investment Objectives and representations."

UPDATE: In a later post, I discuss (here) a sixth lawsuit that has been filed against State Street.

The State Street lawsuits are significant in and of themselves, but also for what they might foreshadow. As I noted above, these lawsuits may well represent the kinds of legal problems that other financial services companies may face, particularly as the mortgages backing many of these investment funds and investment securities continue to detiorate.

There are a number of other important implications from the State Street lawsuits. The first relates to the identity of the claimants – these are very large institutions suing other very large institutions. These lawsuits are not the kind of lawyer-driven stock drop lawsuits that have drawn so much ire from would be reformers. These are conservative business litigants using plaintiffs’ tools seeking to recoup significant losses. These sophisticated litigants may be unlikely to accept quick compromises, and, mindful of their own fiduciary obligations, may well be unwilling to accept any compromise that does not represent a very significant percentage of the losses.

The second important implication of the State Street lawsuits is the sheer magnitude of the dollars involved, as demonstrated by State Street’s pre-tax set aside of $618 million for cases that are only in their earliest stages. The State Street litigation reserve underscores the staggering exposures that these cases and others like it represent. The stakes in these cases are enormous.

The third implication derives directly from the enormity of the financial exposures involved; that is, these cases clearly have very serious repercussions for liability insurers, a consideration discussed in a January 4, 2008 Dow Jones newswire article entitled "Subprime Litigation May Dent D & O Insurers Like Chubb, AIG" (here). The article’s overall conclusion – that the subprime litigation wave may represent a significant concern for D & O insurers – is a valid point that I have in fact previously considered in a prior post (here). However, while I generally agree with the Dow Jones article’s overall thrust, I do disagree with some the article’s premises.

The most egregious of the article’s faulty premises is that the State Street lawsuits represent a D & O insurance exposure. The article disregards the fact that four of the five State Street lawsuits are brought under ERISA. The typical D & O policy contains an ERISA exclusion, primarily because exposures under ERISA are covered under a separate fiduciary liability policy, not a D & O policy.

In addition, none of the five complaints name as a defendant any individuals; there are no director or officer defendants in any of these complaints (although there are John Doe defendants named without further identification in several of the complaints). The entity coverage under the typical D & O policy provide coverage only for securities claims against insured entities, and none of the five complaints raise securities law allegations.

So, contrary to the Dow Jones article’s presumption, the State Street complaints do not themselves appear to embody any particular D & O insurance threat, as in their current forms at least, they would not appear implicate the typical D & O insurance policy. To be sure, the complaints may represent serious threats to fiduciary liability insurers and perhaps even to investment management errors and omissions (E & O) insurers, and to that extent the implication would seem to be that the subprime litigation wave represents a much more extensive threat to the insurance industry beyond just D & O. All of which does indeed suggest that the subprime litigation wave is a potentially complex and serious threat to insurers generally. To that extent, at least, the Dow Jones article is correct when it states that State Street’s reserve "has increased concern that insurers offering policies covering such exposures could be hit with big claims from the credit crisis."

In any event, I do agree that the subprime litigation wave represents a threat to the D & O insurers, even if the State Street lawsuits themselves may not. My prior blog posts on the potential impact on D & O insurers from the subprime meltdown can be found here and here; even though I wrote these posts months age, the analysis still appears more or less valid.

It should also be noted that there have been a number of other subprime related lawsuits brought under ERISA, primarily by employees raising allegations relating to company stock held in the 401(k) plans. A list of these employee ERISA lawsuits may be found in my running tally of subprime-related litigation, here.




The January 6, 2007 New York Times has an article entitled "Testing Investors' Faith in State Street" (here) that examines the market's curious reaction to State Street's announcement concerning its litigation reserve -- its stock price went up, hitting a 52-week high, a response that Times columnist Gretchen Morgenson is at a loss to explain.



Now This: The American Dialect Society has chosen (here) "subprime" as the 2007 Word of the Year. Pondering this development, I was moved to reflect that the subprime meltdown has moved beyond a mere financial event; it has become a cultural, social, and even political phenomenon.


Like all important phenomena, the subprime meltdown has deep roots, which arguably go back to the early 80s when the market for mortgage securities was more or less invented at Salomon Brothers, as entertainingly retold in Michael Lewis’s classic, Liar’s Poker. Though the events described in Lewis’s book took place over twenty years ago, they resonate now with irony and sometimes even ominous portent, although much of the current resonance was perhaps unintended when the words were originally written.


The most portentous segments detail the creation in the mid-80s of the recently eventful mortgage security, the collateralized mortgage obligation (CMO), about which Lewis notes, in words that contemporary investors in Norway, Japan, Australia and the U.K might now rue, that "CMOs opened the ways for international investors who thought American homeowners were a good bet." Lewis also notes, in an observation that seems particularly ironic today, that that as a result of the innovation of CMOs, "investors now had a new, firm idea of what the price of a mortgage bond should be." Lewis goes on to describe how the Wall Street Bankers "found a seemingly limitless number of ways to slice and dice home mortgages."


Space constraints prevent doing full justice to Lewis’s account, so fraught with significance in light of today’s circumstances. Suffice it to say that given recent events, Liar’s Poker merits and rewards a re-reading. It is as entertaining as it ever was, but the description of the invention of the market for mortgage bonds seems to matter in ways that it did not previously.


Special thanks to loyal reader Matt Rossman, who pointed out Liar’s Poker’s newly relevant historical value some time ago – I only recently got around to following up on Matt’s suggestion to re-read the book.

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