August 20, 2010

Lessons from the Credit Crisis: Can Market Participants Bear the Risk? Minimizing Liability from Potential Missteps in the Future

Credit crisis cases serve as reminders that timely and accurate risk disclosure reduces litigation and regulatory enforcement risk.

When declining real estate values and rising mortgage defaults toppled Lehman Brothers and led to an emergency bailout and acquisition of Bear Stearns, the risk previously hidden on the balance sheets of many highly leveraged financial firms became apparent to many investors for the first time. Questions emerged about the quality of disclosures made by Lehman, Bear Stearns, and other firms leading up to the credit crisis and the litigation and regulatory landscape became instantly more perilous for capital market participants. By now, every sector of the market, from public companies and banks to hedge funds and broker-dealers, has seen one or more of its members named in a high-profile regulatory action or private lawsuit. Potential exposure remains high with both regulators and private plaintiffs continuing to pursue possible claims based on issues relating to the credit crisis.

Going forward, capital market participants should understand what the alleged or proven missteps of others teach about minimizing exposure to such issues.

Public Company Lessons: Don't Shortchange Disclosure

Perhaps the key lessons to emerge from the multitude of regulatory and private cases filed in the wake of the credit crisis relate to disclosure--good disclosure practices matter. These are not new lessons, but the credit crisis cases have served as an expensive reminder.

Whether the relevant disclosures related to risk factors, known trends, or simple facts, companies that got it right (e.g., ACA Capital Holdings, No. 1:07-cv-10528-RWS (S.D.N.Y. Jan. 12, 2010)) escaped the worst regulatory and private litigation consequences. Companies that looked for reasons to avoid disclosure or failed to update disclosure as the credit crisis unfolded are still suffering the pain of regulatory scrutiny and private litigation. The suffering is even worse for companies with investors who were able to allege offering fraud under the Securities Act since such claims do not impose heightened pleading requirements for scienter or, in most cases, fraud. Those cases, in particular, are surviving motions to dismiss, and the exposure is high.

Many credit crisis cases illustrate the importance of good disclosure practices; here are a few to consider.

Establish a Positive Disclosure Culture: Bank of America

In September 2008, as Lehman Brothers teetered on the brink of bankruptcy, Merrill Lynch sought a savior in Bank of America (BOA). Merrill's chairman and CEO John Thain contacted BOA chairman and CEO Kenneth Lewis on Saturday, September 13, 2008, to discuss a strategic combination of the two companies. A merger agreement was announced two days later.

Each company filed proxy statements with the SEC and sent them to their shareholders, scheduling shareholders' meetings to vote on the merger for December 5, 2008. Bank of America filed a registration statement for the shares of stock to be exchanged with Merrill. BOA's proxy and registration statements provided financial information for both BOA and Merrill, as of the end of September 2008. SEC proxy and registration rules required BOA and Merrill to describe any material changes in Merrill's business condition before the shareholder vote.

By the time of the December 5 shareholder meeting, according to the SEC, BOA had become aware of $4.5 billion in net losses that Merrill had sustained in October and also estimated that Merrill had lost billions more in November. A net loss of over $7 billion was forecast for the quarter. According to the SEC, this "disastrous performance" was not reported to shareholders. In addition, prior to the December 5 shareholder meeting to approve the merger, BOA failed to disclose that it agreed that Merrill could pay $3.6 million in discretionary bonuses to its employees.

Without any updated information, BOA shareholders approved the merger. Six weeks later, Bank of America disclosed Merrill's performance for the fourth quarter of 2008. Merrill had sustained a net loss of $15.3 billion, the largest quarterly loss in the firm's history. The next day, BOA's stock price dropped nearly 30 percent.

Shareholders filed securities fraud, ERISA, and derivative lawsuits; the New York attorney general (NYAG) filed a civil fraud action; and the SEC sued BOA twice, in August 2009 and January 2010. These lawsuits allege that BOA lied to its shareholders about Merrill's bonus payouts and about Merrill's materially worsening financial condition in connection with the December 5, 2008, shareholder's vote. After first rejecting a proposed SEC settlement including a $35 million penalty, in February 2010, the court approved BOA's settlement with the SEC (the other actions against BOA are still ongoing). SEC v. Bank of America Corp., Nos. 09-6829, 10-0215 (S.D.N.Y. 2010). BOA agreed to pay $150 million and to implement a series of internal control improvements that read like a good corporate disclosure and executive compensation checklist, including

  1. Evaluation of its disclosure controls;
  2. Evaluation of the qualifications of members of the disclosure committee;
  3. Certification by the CEO and CFO of proxy statements;
  4. Retention of disclosure counsel to report to the audit committee;
  5. Establishment of a wholly independent compensation committee;
  6. Implementation of formal written incentive compensation policies and principles and publication of those policies on the company website; and
  7. Giving shareholders a nonbinding "say on pay."

In approving the SEC settlement, the court found that "the relevant decision-makers took the position that neither the bonuses nor the mounting fourth quarter losses had to be disclosed because the bonuses were consistent with prior years' bonuses and the losses were uncertain and, in any case, roughly consistent with prior quarters." The court was blunt; that assumption was "erroneous." In the words of the court, "[g]iven that the apparent working assumption of the Bank's decision-makers and lawyers involved in the underlying events at issue here was not to disclose information if a rationale could be found for not doing so, the proposed remedial steps should help foster a healthier attitude of 'when in doubt, disclose.'"

"When in doubt, disclose" is a disclosure approach sometimes forgotten as companies and their advisers consider such issues. Too often disclosure decisions are made with exactly the focus criticized by the court in BOA. The "negligent" disclosure failures alleged by the SEC led to an expensive settlement for the company, and senior BOA executives are facing potential personal liability in the NYAG's case. With such a high-profile reminder of what constitutes the right approach to disclosure, however, those who fail to pay attention could face even worse consequences. To help foster the right disclosure culture, companies should consider whether to implement into their own governance structure some of the practices outlined in the BOA settlement.

Update Risk Disclosures and Timely Report Known Trends: Subprime Lenders

Subprime mortgage lenders were at the heart of the real estate maelstrom. Lending practices such as no-money-down, negative interest, and no-paperwork loans helped fuel a buying binge that inflated the value of real estate and, later, substantially increased mortgage default rates. After the bubble burst, those holding subprime mortgages or securities backed by these mortgages, in many cases the originators themselves, saw the value of their assets quickly diminish. As values declined, the secondary market for subprime mortgage-backed securities dried up and originators were left with no means of raising capital, disabled lending operations, and the ire of investors and regulators.

The SEC and private plaintiffs have brought civil actions against several of the nation's largest subprime mortgage lenders alleging that they failed to adequately and timely disclose risks associated with their businesses. In a number of these cases, the allegations include claims that while officers of these companies knew of declining loan quality and loosened underwriting guidelines employed by their company, they made specific public statements in SEC filings, press releases, and earnings calls assuring investors that their company's loan quality remained sound and that the company continued to employ strict underwriting guidelines. According to the complaints, these lenders waited too long to reveal what they knew about the deteriorating markets and their deteriorating business models.

In 2009, the SEC sued officers of lenders such as American Home Mortgage Investment Corp., Countrywide Financial Corp., and New Century Financial Corp., alleging that as market conditions for their businesses deteriorated, these lenders failed to disclose important negative information, including, for example, dramatic increases in early loan defaults and increasingly risky lending practices. E.g., SEC v. Morrice et al., No. SACV09-01426 JVS (C.D. Cal. Dec. 7, 2009); SEC v. Mozilo et al., No. 09-03994 (C.D. Cal. June 4, 2009).

In SEC v. Strauss et al., No. 09-4150 (RB) (S.D.N.Y. Apr. 28, 2009), the SEC alleged that New Century's executives were responsible for the company's failure to disclose known negative information. Although New Century's SEC filings contained a "Risks" section that described the greater risk of default attached to New Century's interest-only loan origination business and the greater risk of loss in New Century's no-money-down loans, the SEC alleged that those disclosures were misleading because they only discussed potential losses and failed to disclose known negative information, such as the fact that New Century was actually experiencing greater defaults on its no-money-down loans.

Private investors also sued based on similar allegations of failure to disclose known, material negative information relating to the impact of deteriorating markets. Although American Home Mortgage filed for bankruptcy, the case against individual officers, the company's auditors, and underwriters of its securities settled for approximately $37 million prior to any motions to dismiss. New Century also filed for bankruptcy, but claims against its officers, directors, auditors, and underwriters survived a motion to dismiss. Multiple private actions against Countrywide executives, underwriters, and auditors premised on a range of alleged violations and breaches of duty remain pending in both state and federal courts having survived, at least in part, dismissal motions.

The allegations in each of these cases and others similar to them highlight key areas of attention going forward:

(1) Companies should update risk disclosures and make them specific, describing events that are likely to cause the risk to materialize—New Century is an example of the consequences of a failure to take such steps. In re Ambac Financial Group, Inc. Securities Litigation, No.08 Civ. 4111 (S.D.N.Y. Feb. 22, 2010), illustrates the benefits of getting disclosure right (and the perils of getting it wrong). In Ambac the court dismissed some claims noting that the prospectus at issue contained sufficiently specific risk factors that put investors on notice. Other claims were not dismissed because the risk factors in the relevant prospectus did not contain sufficiently specific risk factors.

(2) As risks become reality, companies should amend the MD&A section of their public filings to disclose those events as, at a minimum, known trends or uncertainties (e.g., when New Century's interest-only loans began to default at higher rates); and

(3) Public communications through press releases and in conference calls must coincide with internal views of how the company is performing. In Ambac, the court allowed claims to proceed where statements by company representatives in press releases and conference calls created "a vast gap between the picture . . . presented to shareholders . . . and the alleged practices within the company." Careful monitoring is important to prevent such disclosure gaps.

Consider Whether the Investigator May Have a Conflict: Lehman Brothers

Of the many issues that have emerged as a result of the Lehman Brothers bankruptcy, In re Lehman Brothers Holdings Inc., No. 08-13555 (S.D.N.Y. 2009), the issues surrounding the company's use of an undisclosed accounting mechanism, "Repo 105," have recently taken center stage. At least two dozen other companies are reportedly facing SEC inquiry related to their possible use of the same accounting technique. What may make Lehman Brothers unique is that prior to the company's bankruptcy, a whistleblower apparently raised issues relating to Repo 105 and the audit committee investigating the whistleblower's concerns did not learn about that aspect of his claims even though he raised the issues with the investigators (in this case, Lehman's independent auditors). Assuming that is what occurred, audit committees and others responsible for safeguarding disclosures (as well as accurate financial reporting) can learn from what reportedly occurred at Lehman.

As described in the report of Lehman's bankruptcy examiner, the company was highly leveraged and funded its daily operations through the repurchase or "repo" market by selling billions of dollars in financial assets daily and agreeing to repurchase the assets within a few days. Lehman relied on favorable ratings from the principal debt ratings agencies to support its high-leverage business model. Lehman's net leverage and liquidity were key metrics for ratings agencies. In the second quarter of 2008, Lehman announced a quarterly loss of $2.8 billion resulting from, among other things, write-downs and sales of subprime assets and decreasing revenues.

Lehman allegedly cushioned the announcement by emphasizing that it had significantly reduced its net leverage ratio and also had a strong liquidity pool. Lehman did not disclose that its net leverage ratio was reduced through the use of what company insiders called "Repo 105" transactions. Repo 105 transactions worked like normal repo transactions, which were accounted for as financings--Lehman sold assets with a simultaneous obligation to repurchase them within a few days--but the asset values were 105 percent or more of the cash received. Lehman treated the Repo 105 transactions as sales rather than financings, allowing the firm to report materially lower net leverage for the second quarter of 2008. Lehman reportedly did not disclose the use of Repo 105 transactions in its public filings.

According to the examiner, "Lehman used Repo 105 for no articulated business purpose except to reduce balance sheet at the quarter-end." The use of these undisclosed transactions and Lehman's increasing reliance upon them to "reduce its balance sheet and reverse engineer its leverage," in the words of the examiner, "created a misleading portrayal of Lehman's true financial health." According to the examiner, colorable claims exist against the Lehman officers who were responsible for balance sheet management and financial disclosure and who failed to disclose Lehman's use of Repo 105 transactions.

Since the passage of the Sarbanes-Oxley Act of 2002 (SOX), audit committees play a key oversight role in public company disclosures. The audit committee safeguards the integrity of a company's financial statements by working with the company's independent accountant and closely reviewing critical accounting policies and practices. Audit committees are charged with investigating issues related to financial reporting.

Prior to Lehman's collapse, a senior vice president in Lehman's finance division wrote a letter expressing serious concerns about Lehman's accounting practices; when interviewed during the resulting investigation, the whistleblower specifically identified Repo 105 as an area of concern. It appears from the examiner's report that the audit committee's selected investigator of the whistleblower's allegation, Lehman's independent auditor, did not fully inform the audit committee about the allegations despite a request that it do so.

How can audit committees minimize the risk of an investigator who doesn't provide full information? Lehman teaches several lessons:

(1) When deciding who should help investigate an issue, audit committees should consider whether the proposed investigator may have a conflict or interest in the outcome; while usually an independent auditor may be the right choice, where serious accounting issues are raised, an auditor whose audit procedures could come into question may not be the right choice. The issue of a potentially conflicted investigator first came into prominence in Enron where the sufficiency of the investigation conducted by a law firm looking into a whistleblower complaint was questioned due to perceived conflicts and alleged interest in the outcome of the investigation.

(2) Where the whistleblower has identified himself, as in Lehman, the audit committee should consider having one of its members participate in an initial, direct interview of the whistleblower with the investigator so that there is an opportunity to learn about all of the issues firsthand. Thereafter, the audit committee should periodically seek updates regarding those issues and possible newly discovered issues.

(3) Where the whistleblower is anonymous, the audit committee must take particular care to keep itself informed of the issues under investigation through repeated contact with the investigator, including review of interview notes.

Broker-Dealer Lessons: The Auction Rate Securities Cases

Beginning in 2008 and extending into 2010, the NYAG and SEC announced a string of settlements with underwriter securities firms and downstream brokers of auction rate securities (ARS) that was a veritable who's who of Wall Street firms. It seemed that nearly every large bank, investment firm, or broker-dealer was charged with misrepresentations in connection with ARS.

ARS are long-term bonds that rely on the successful operation of periodic auctions for short-term liquidity. The general theme of the government's allegations was that many customers bought ARS on the understanding that ARS were safe, liquid investments. ARS underwriters and brokers allegedly failed to inform customers of the risk that auctions could fail and they would not be able to get their money back.

According to court filings, many brokers were not trained and did not understand ARS risk. They advised clients that ARS investment was similar to money market funds or certificates of deposit. Brokers allegedly did not explain risks in the ARS market to their clients. One broker allegedly guaranteed that his customer would be able to "get out of [his ARS] on the auction date." Another broker described ARS as a "short-term institutional holding instrument" suitable for cash balances. Some registered representatives acknowledged they did not understand that customers might not be able to sell ARS.

As the value of mortgages and other assets underlying asset-backed ARS began to deteriorate, the ARS market followed, causing firms to have to purchase additional inventory to prevent failed auctions. At the same time, however, the firms knew that their ability to support auctions by purchasing more ARS had been reduced because the credit crisis stressed the firms' balance sheets. When auctions began to fail, brokers allegedly did not disclose that fact to customers/investors.

According to the NYAG, the alleged fraud was only possible because broker-dealers "failed to train or otherwise ensure that its brokers had even a basic understanding of auction rate securities." There are a number of steps that can be taken by broker-dealers to reduce the potential liabilities associated with offering risky securities beyond those articulated in FINRA's supervisory control rules. Adequate understanding and disclosure of the securities' risks are the most important steps to reducing potential liability.

In addition, a broker-dealer's standard review of registered representatives' transactions and correspondence should be supplemented when selling riskier products. Broker-dealers should ensure that registered representatives are qualified by virtue of experience or training to sell the products. The broker-dealer should exercise greater supervision over registered representatives and should conduct periodic in-depth internal reviews focused specifically on the riskier business line to ensure compliance with securities laws and regulations and FINRA rules. Broker-dealers also should consider taping and reviewing phone conversations of those registered representatives selling high-risk securities, even if not required to do so under the circumstances by FINRA rules.

Hedge Fund Lessons: Don't Shortchange Disclosure--the Bear Stearns Funds

In June 2008, the DOJ and SEC brought charges against two Bear Stearns hedge fund managers, Ralph Cioffi and Matthew Tannin, whose two highly leveraged funds (the "Bear Stearns Funds" or "Funds") collapsed in June 2007 under the weight of their subprime investments. U.S. v. Cioffi et al., No. 08-00415 (E.D.N.Y. June 19, 2008); SEC v. Cioffi et al., No. 08-2457 (E.D.N.Y. June 19, 2008). The collapse of the Funds caused investor losses of almost $2 billion and nearly bankrupted Bear Stearns, which was forced to seek a rescue acquisition by JPMorgan Chase.

While Cioffi and Tannin were acquitted of criminal charges, the SEC case is ongoing. According to the SEC, as the Funds suffered increasing losses in the first two quarters of 2007, Cioffi and Tannin "deceived their own investors, as well as the Funds' institutional counterparties, by fraudulently concealing from them the full extent of the Funds' deepening troubles." Additionally, the two hedge fund managers persuaded investors not to withdraw their money by misrepresenting the level of redemptions from the Funds, the current outlook of the Funds, and the composition of the Funds' portfolios. Cioffi allegedly told investors, during a conference call, that the Funds had only a couple of million dollars in scheduled redemptions when, in reality, they had approximately $110 million in scheduled redemptions at that time. After Cioffi and Tannin allegedly touted their own investments in the Funds as a selling point, Cioffi sold off $2 million of his personal investment in one of the Funds. He did so allegedly without informing investors.

The SEC's complaint further alleged that Cioffi and Tannin misrepresented the Bear Stearns Funds' investments in subprime mortgage-backed securities. According to the complaint, monthly written performance summaries highlighted direct subprime exposure as typically about 6 to 8 percent of each fund's portfolio. Allegedly, however, total subprime exposure—direct and indirect--was approximately 60 percent.

The SEC alleged that Cioffi and Tannin's investor communications failed to adequately inform investors of the escalating risk in 2007 that the Funds would fail. Cioffi and Tannin's failure to report the Funds' concentration and losses in subprime securities, for example, falsely suggested that the Funds were less risky than they actually were. Cioffi's alleged overstatement of his personal investment in one of the Funds created a misimpression that the fund manager believed the Funds presented an acceptable level of risk.

Hedge funds do not have the strict disclosure requirements that SEC registered funds and public companies have. There is no check-the-box style SEC Form disclosure for hedge funds to rely on. Nevertheless, the antifraud rules of the securities laws apply to hedge fund disclosures. With additional regulation looming large and increased regulatory energy, hedge funds must act to insure that they do not run afoul of already-existing rules

Hedge fund advisers need to understand and fully disclose the risks associated with their investment strategies, and provide full facts about the performance of the investments. The SEC's case against Bear Stearns is about a failure to accurately disclose the risks associated with an ongoing investment in the Funds. As markets faltered in 2007 and subprime and collateralized debt obligation investments were rapidly losing value, Fund investors sought assurances from Cioffi and Tannin that their investments were safe. For their part, Cioffi and Tannin allegedly sought to avoid the type of investor panic that causes a run on the bank and dooms every leveraged fund to liquidation. Circumstances like these present a real conflict of interest. The adviser needs to reassure investors to avoid a death spiral of redemptions and investors want to hear about and plan for the worst-case scenario. The only way for a fund manager to bridge that gap and fulfill his fiduciary obligations to investors is through adequate disclosures.

If an adviser chooses to accept the pressures of running a high-leverage, high-risk fund, at a minimum, the adviser should consider engaging experienced disclosure counsel to assist with investor communications so that the quality of disclosure in good times is consistent with and measured in relation to disclosures made in bad times. In bad times, the fund should consider having disclosure counsel sit in asset valuation meetings and meetings with the fund's independent accountant. Shifting securities holdings should be continuously evaluated against portfolio descriptions in fund offering documents.

Of paramount concern, risks must be accurately reported. Boilerplate disclosures in a risks section of an offering or subsequent disclosure document are insufficient when a fund is facing material, identifiable, adverse conditions. Identifiable threats and evolving exposure must be accurately and fully described in timely communications to investors.


While the conditions that created the recent credit crisis are somewhat unique, the causes of action brought against the market participants discussed above are timeless. These high-profile cases demonstrate that the stakes for basic disclosure failures have never been higher. Market participants and regulated entities should keep these cases in mind and regard them as valuable points of reference in disclosure discussions and training exercises.