The collapse of Bear Stearns last month may not have the notoriety of corporate implosions like Enron, WorldCom, or Arthur Andersen. Still, the consequences of the investment bank’s fall could be just as far-reaching.
One thing is certain: Bear Stearns’ demise will not be the lone symbol of the sub-prime age, but merely the beginning of hundreds of other sub-prime-related lawsuits rapidly coming down the road.
Jeff Nielsen, director of risk management services at Navigant Consultants, says the inevitable litigation will be based on the outcome of pending regulatory investigations, the continued deterioration of the credit markets, and other spectacles like the Bear Stearns failure.
“In 2007 alone there were 278 lawsuits filed in federal court,” Nielsen says—compared to 559 lawsuits over six years in the 1980s, during the peak of the savings-and-loan crisis. “You’re seeing nothing less than a stampede of sub-prime-related suits. There’s no indication that so far this year there’s been any letting up or easing of that pace.”
Hence, companies that acquire distressed lenders (such as JP Morgan Chase, which is trying to scoop up Bear Stearns for $10 per share) will face residual litigation risks as a result of their purchases. In the same way that Sarbanes-Oxley brought increased compliance costs to legions of innocent companies, Corporate America should expect much the same when regulators and lawmakers formally react to the lasting effects of the credit crisis.
As the lawsuits mount, many observers believe that a large portion of the disputes will reveal a breakdown in internal controls. Some possibilities: improper management overrides at banks to issue loans; false booking of assets or recording of inflated collateral values at mortgage brokerages; and ill-informed—if not intentionally erroneous—ratings on corporate debt from credit rating agencies.
In the case of banks and the publicly traded firms they did business with, Adam Savett, head of securities class-action services for RiskMetrics Group, contends that the compliance departments at some of these businesses should have stepped up and said, “Wait a minute.”
“We thought we had seen the last of these murky acronyms like SPE [special purpose entity], and we thought we got rid of them when Sarbanes-Oxley came into play,” he says. “But it turns out they just renamed them.” He cites structured investment vehicles (SIVs), collateralized debt obligations (CDOs), and auction rate securities (ARSs) as the new generation of financial instruments few really understand.
Savett tracks cases from filing to final resolution for corporate clients and also processes legal claim forms for institutional clients. The fallout from the credit crisis is only in its infancy, he says. Companies with direct exposure, as well as institutional shareholders and other investors with indirect exposure, will all have legal concerns that could go to court.
Savett predicts that Bear Stearns is only “the latest in a fairly long-term string of securities class-action suits going forward.”
“This thing started off where the defendants were mostly mortgage lenders, home builders, and investment bankers, and it was cut and dry and nice and neat and clean,” he says. “Now it’s starting to spread rapidly to other corporate arenas.”
Guarding Against Liability
Like Enron and the savings-and-loan crisis before it, the credit crisis will also force companies to re-examine their directors-and-officers and errors-and-omissions insurance. Once considered a formality, D&O and E&O insurance now figure prominently in discussions about “tone at the top” risk mitigation at many public companies.
In a January report titled, “Sub-prime-related Writedowns: Potential Exposure to D&O and E&O Insurers,” insurance consulting firm Advisen Ltd. estimated that $170 billion has evaporated from the balance sheets of public companies worldwide due to the sub-prime malaise. That figure may be the tip of the iceberg, according to the report.
Advisen estimates that of the 112 companies reporting sub-prime-induced writedowns to date, as much as $1.2 trillion in CDOs and other convertible mortgage-backed securities may be listed as assets on the balance sheets of these concerns that may soon turn into liabilities. Once that happens, expect the plaintiff lawyers to come sniffing around.
Kevin LaCroix, a partner at Oakbridge Insurance Services and writer of the D&O Diary blog, has identified 49 securities class-action lawsuits stemming from the credit crisis; 10 were filed in the first three months of 2008.
LaCroix notes that the only difference between the S&L crisis of the 1980s and the credit crisis of today is that today’s meltdown is more wide-reaching—because it includes ”everyone from lenders to mortgage servicers and originators to bond insurers to rating agencies involved to the point where this is bound to move beyond the financial sector.”
To illustrate that point, La Croix cites pharmaceuticals giant Bristol Meyers Squibb. It had to write down $275 million in fourth-quarter losses as a direct result of holding CDOs suddenly worth much less than what the company had expected.
La Croix also refers to mobile phone group Metro PCS and its suit against Merrill Lynch. Metro holds the investment bank liable for losses related to $139 million in cash reserves it entrusted to Merrill. According to the suit, as much as $20 million was lost from investments in auction-rate securities that Metro PCS held as a cash equivalent in its investment portfolio.
But LaCroix said it’s too soon to measure the magnitude of the litigation wave and its subsequent effect on D&O insurance, as many cases will be dismissed or settled or will take years to conclude.
“This emerging environment will significantly affect the price of and stability of insurance policies for corporate directors and officers in the long run,” LaCroix says. “This is true, especially if the pace of lawsuits quickens, or if we start to see some large plaintiff judgments. All in all, though, I don’t think you’ll start to see what these results will truly mean for D&O insurers until probably the end of 2009.”