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Sub-prime Litigation: It’s Only Just Begun

By Tammy Whitehouse — September 30, 2008

nprecedented government-led bailouts of cornerstone financial institutions serve as an indicator that the tidal wave of litigation over failed sub-prime mortgages has hardly even begun.

“If sub-prime litigation is a nine-inning ball game, we’re only in the top of the second inning,” says Kevin LaCroix, an attorney and partner in management liability insurer OakBridge Insurance Services. Rescues for Fannie Mae, Freddie Mac, Lehman Brothers, and AIG, for example, will lead to a surge of new legal claims, says LaCroix.

According to Fritz Chockley, a partner with Baker Hostetler and coordinator of the firm’s litigation practice group, several hundred suits already have been filed with U.S. court dockets all over the country—so much so that sub-prime is becoming a “sub-industry within the legal market.” The nature of the claims runs the gamut; borrowers are suing lenders, investors are suing institutions that packaged and sold bad loans, shareholders are suing institutions that now are recognizing deep losses, and in some cases institutions are even suing one another.

Securities class-action suits represent a sizable chunk of the total universe of sub-prime claims so far, legal experts say. Adam Savett, director of RiskMetrics Group’s securities class-action services, says he’s counted 120 securities class-action cases that have materialized in the court system so far.

Cases are just beginning to emerge involving not direct exposure to sub-prime lending problems, but secondary exposure, he says. Untold scores of companies have toxic assets on their books that are not trading, but the financial statements don’t yet fully reflect the writedowns, Savett says.

LaCroix agrees. “The companies are so large, their securities are so widely held, the events are so widespread throughout the economy—you’ll have companies that had no direct exposure to the credit crisis before now finding themselves exposed.”

“Many companies so far have chosen to do the ostrich routine—stick their heads in the sand,” he says. “You can get away with that for a single, two, even three quarters, but when the auditors come in for their year-end review it starts to get a little more difficult to say you can’t mark-to-market.”

In the arena of securities class actions, cases have some new hurdles to clear under the Private Securities Litigation Reform Act and recent Supreme Court findings to even get a day in court. PSLRA sought to end abusive litigation practices by requiring plaintiffs to more clearly state their claims upfront and back them up with facts showing fraudulent intent. Subsequent Supreme Court rulings in cases against Dura Pharmaceuticals and Tellabs have secured the notion that cases need to be grounded in clear facts to get a serious look by the legal system.

Only a handful of class-action cases filed so far have navigated the preliminary stages to see whether they’ll generally stand up to the new standards, says Grace Lamont, a partner at PricewaterhouseCoopers and leader of the firm’s securities litigation practice. “It seems to be quite mixed in terms of the dismissals that are occurring,” she says. “Everyone is saying it’s too soon to determine.”

Savett says most defendants facing such cases are still working to prepare their motions for dismissal, asking judges to toss the cases based on a preliminary view of its ability to hold up under the PSLRA standards. He says fewer than 10 such motions have been filed so far, with no more than five cases dismissed and at least a few motions denied, allowing the cases to go forward.

Given the scope of the legal fight ahead, those numbers are hardly enough to establish a trend, says Savett. LaCroix predicts the battle lines are more likely to emerge along the lines of economic forces. The claims and the defense arguments will be similar across cases, he says. The differences will lie in the extent to which judges agree that losses were caused by economic circumstances, not management activity or failure to disclose.

“Where motions to dismiss are granted, it’s where the courts are persuaded by arguments that larger economic forces are at work,” he says. “On the flip side, in cases where motions to dismiss are denied, courts will have been very persuaded by allegations related to insider trading or other indicators of personal benefit to management.”

Savett even questions the extent to which PSLRA and the Dura and Tellabs decisions actually raise the bar in some courts. “It codified the standard that applied in some courts, but it did raise the threshold in other courts,” he says, establishing a level playing field across the court system.

Chockley says the early 2008 dismissal of Gold v. Morrice in the central district of California might be instructive to future prospective plaintiffs to see how the new pleading standards are being applied to sub-prime-related claims. The case was dismissed “without prejudice,” Chockley says, signaling the court isn’t dismissing on the merits of the claim itself but more on a procedural basis.

“That means the claim as stated is insufficient under the law and the courts’ rules, but it gives the plaintiffs permission to amend the complaint and try again with no penalty imposed,” he says. The Gold case is a complex one in which shareholders sued officers, auditors, and others over the collapse of New Century Financial Corp.

By contrast, LaCroix points to a case against a high-end homebuilder where the motion to dismiss was denied. A California pension fund sued Toll Brothers, Inc. and adequately spelled out in the initial complaint, in the court’s view, that the builder inflated earnings projections to raise new capital, despite undisclosed adverse developments to the contrary.

“We have much, much farther to run,” LaCroix says. “We can’t draw conclusions from a limited data set.”

An even bigger question is where funds would materialize to pay damages if plaintiffs are successful in winning cases. “There’s a big hurricane blowing across Wall Street right now,” says Chockley. “Some of these institutions are going to be wiped out. Nevertheless, people have these claims and they’re going to pursue them, certainly.”

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