INSIDE THIS ISSUE
This past month, Goldman Sachs cemented its legacy as the face of corporate greed and fraud during an era of widespread misconduct that led to the worst economic crisis since the Great Depression and prevalent investor distrust in the financial markets. As widely reported, on April 16, 2010, the Securities and Exchange Commission (the “SEC”) brought a civil action against Goldman, a global investment banking and securities firm, concerning a collateralized debt obligation (“CDO”) known as “ABACUS 2007-AC1.” CDOs are structured asset-backed securities whose values are derived typically from fixed income underlying assets. In this case, ABACUS’s value was based on the performance of subprime residential mortgage-backed securities. The presence of those mortgage-backed securities, however, does not alone serve as the crux of the SEC’s case. Instead, the case alleges that Goldman failed to disclose material information in its marketing of ABACUS 2007.
The alleged fraud involves one of the world’s largest hedge funds—Paulson & Co. According to the SEC’s complaint, Paulson paid Goldman $15 million to structure ABACUS in a way in which it could take short positions against subprime mortgage-backed securities that it, itself, chose to include in the CDO. Then, after selecting the securities, Paulson allegedly would short that portfolio by entering into credit default swaps with Goldman, thus creating an incentive to select securities that would likely default. Crucially, none of this was disclosed to investors in ABACUS. In fact, Goldman represented to investors that the mortgages selected were done by an independent third party.
Eventually, ninety-nine percent of the mortgages making up ABACUS were downgraded, as Paulson engineered it. As a result, investors on one side of the transaction lost $1 billion on ABACUS 2007-AC1, while Paulson's hedge fund, which was on the other side of the deal, made $1 billion The SEC alleges that Goldman and its Vice President, Fabrice Tourre, who allegedly was responsible for structuring of the transaction, violated Section 17(a) of the securities Act of 1933, Section 10(b) of the Securities Exchange Act of 1934, and Exchange Act Rule 10b-5.
On the heels of the SEC’s filing, a Senate Subcommittee spent over ten hours on April 27, 2010 questioning executives at Goldman about their aggressive marketing of mortgage investments during the years when it was clear the housing market was on the brink of collapse. In particular, Senators questioned Goldman on how and why it could have sold investments that its own sales team knew were worthless and, in fact, had described in obscene terms. Goldman executives, including its Chairman and CEO, while being barraged with questions and direct quotations from internal e-mails, continued to deny any wrongdoing whatsoever and to minimize any amount of money made by Goldman from subprime mortgage-backed securities, including those involved in ABACUS.
It was clear from the opening remarks of the ten hour hearing that, although Goldman was being targeted, the investigation also addressed the role of investment banks and their questionable actions in late 2006 and 2007 that directly caused the 2008 financial crisis. It is likely that further Senate Subcommittee hearings will be held as the government decides what, if any further regulations to put in place to avoid future situations like ABACUS.
In addition, more SEC cases against other investment banks concerning their actions related to the housing meltdown are likely. In fact, SEC Chairman Mary Shapiro has stated that the organization has been building up its staff to obtain persons with the requisite knowledge and experience in order to bring more lawsuits involving investment firms’ actions leading up to the financial crisis. Chairman Shapiro stated that now that this staff increase has been completed, more cases against banks are “in the pipeline.”
On Tuesday, April 27, 2010, the U.S. Supreme Court issued a unanimous opinion in the Merck & Co, Inc. v. Reynolds, et. al. securities class action that represents a significant victory for all investors.1 The Supreme Court’s opinion specifically held that Merck investors’ federal securities fraud claims against the company were not barred by the statute of limitations, in spite of Merck’s contention that the suit was filed too late under the two-year statute of limitations contained in the Sarbanes-Oxley Act of 2002. The ruling stated that the limitations period in federal securities actions does not begin until the plaintiff discovers, or a reasonable plaintiff would discover, facts constituting a violation of securities law, including scienter (i.e., the intent to defraud).
The opinion, written by Justice Stephen Breyer, allows investors suing Merck & Co., Inc. for allegedly misleading them about risks of the now-withdrawn anti-inflammatory drug Vioxx to continue with their case. The ruling affirms an earlier decision by the U.S. Court of Appeals for the Third Circuit, which had reversed a decision by the U.S. District Court for the District of New Jersey to dismiss the case as time-barred.
Under Sarbanes-Oxley, an investor-led securities action may be brought not later than the earlier of “(1) 2 years after the discovery of the facts constituting the violation; or “(2) 5 years after such violation.” In Merck, the Supreme Court was tasked with determining when the two-year statute of limitations begins to run. Merck had claimed the two-year limitations period started when the potential plaintiffs receive a notice that something might be amiss at a target company. The investors, joined by the U.S. government, had argued that the limitations period began when a “diligent investigation” could or would have provided enough facts to bring fraud allegations, including facts to demonstrate scienter. Investors maintained that they only learned enough to allege scienter less than two years before they filed their lawsuit.
After reviewing the text of not only Sarbanes-Oxley, but also the Securities Exchange Act of 1934 and the Private Securities Litigation Reform Act, the Supreme Court determined that the two year statute of limitations for securities fraud actions under the “discovery rule” does not begin to run until an investor actually discovers or reasonably would have discovered the facts of the fraud violation, including whether the company acted with scienter. The Supreme Court recognized that a contrary rule would effectively reward defendants who successfully conceal their involvement in fraudulent conduct, because otherwise, as the Supreme Court stated, “so long as a defendant concealed for two years that he made a misstatement with an intent to deceive, the limitations period would expire before the plaintiff had actually discovered the fraud.”
The Merck holding is a key victory for all investors because investors injured by securities fraud now know that the two-year statute of limitations period does not begin to run until they can reasonably be expected to adequately plead all the key elements of their claim, including defendants’ fraudulent intent. This allows investors, who may have grounds to suspect fraudulent conduct, to collect sufficient facts to adequately plead fraud in a complaint against all potential wrongdoers. As the recent economic crisis and the Goldman Sachs civil suit (discussed in this newsletter) have demonstrated, securities frauds are usually extremely complex and designed to conceal the truth. Therefore, the process of collecting sufficient facts will often be a time-consuming task. The Supreme Court’s opinion in Merck enables investors to thoroughly investigate securities fraud before filing a claim.
1 Merck & Co, Inc. et. al. v. Reynolds, et. al., No. 09-902, 559 U.S. (April 27, 2010).
In a decision issued on March 31, 2010, the U.S. Supreme Court allowed a plaintiff to bring a class action in federal court even though the plaintiff could not have brought the class action in state court. The decision, Shady Grove Orthopedic Associates, P.A. v. Allstate Insurance Co.,2 could have a far-reaching impact by increasing the number of legal claims brought as class actions in federal courts. “We hope the decision will benefit our clients and those they stand for in class actions that seek to right corporate wrongdoing,” said partner Christopher M. Burke of Scott+Scott LLP.
A class action is a legal procedure that allows an individual to bring claims on behalf of others who suffered similar harms. In a class action lawsuit, the named plaintiff serves as the class’s representative and stands in the shoes of those who suffered similar harms.
Some laws prohibit the use of class actions for certain types of claims, forcing individuals to prosecute their claims separately. For example, in Shady Grove, the plaintiff brought a class action lawsuit premised on a New York insurance law that awarded a statutory interest penalty of 2% per month for overdue insurance benefits. The New York class action law, however, prohibited the class action procedure from being used with the insurance law. Thus, under New York law, plaintiff Shady Grove could not bring its claim as a class action.
Shady Grove had provided medical services to Sonia Galvez for injuries she suffered in a car accident. As partial payment, Shady Grove accepted an assignment of Ms. Galvez’s insurance benefits. The insurer, Allstate, had 30 days to pay the claim, but it did not pay on time. Under New York insurance law, Shady Grove became entitled to the statutory interest penalty of 2% per month.
Shady Grove brought a lawsuit in federal court to recovery the unpaid statutory interest, which had accumulated to about $500. Shady Grove brought its claim as a class action, seeking to represent other similarly-situated Allstate customers who were allegedly entitled to statutory interest for overdue benefits.
Even though the New York law defining when class actions can be brought prohibits the class action procedure to be used with the insurance law on overdue insurance benefits, the Supreme Court did not consider itself bound by the New York class action law. Instead, the Court held that the federal class action procedure (“Rule 23”) governed, and there is no prohibition in Rule 23 for the type of claim Shady Grove brought, entitling Shady Grove to pursue the claim as a class action.
Whether the New York class action statute or Rule 23 applied arose as questions during the lawsuit because federal courts sometimes adjudicate state law claims in certain unique situations. The situation in Shady Grove that allowed the plaintiff to bring its New York state law claim in federal court was that Shady Grove was a Maryland corporation, and Allstate was a New York corporation. When the plaintiff and defendant are residents of different states, the plaintiff may bring the claim in federal court if the claim is worth more than a threshold dollar amount.
This situation, called diversity jurisdiction, raises questions about whether the federal court should apply state or federal procedural law when adjudicating the lawsuit. The rule is that when a federal court has diversity jurisdiction over a state law claim, the court applies federal “procedural” law and state “substantive” law. Procedural laws are basically housekeeping rules about how the case makes its way through the litigation cycle – for example, pleading standards, summary judgment standards, pre-trial discovery rules, and the admissibility of evidence. Substantive laws define legal rights and duties. In Shady Grove, for example, the substantive law was the New York insurance law on overdue benefits.
The precise question before the Court was whether New York’s class action law was a substantive or procedural law. If New York’s law was substantive, it applied, whereas if New York’s law was procedural, Rule 23 applied. The decision, which is divided into five separate opinions, shows that the distinction between procedure and substance is not easily applied. In short, the Court determined that the New York class action law was procedural, and, therefore, Rule 23 applied in the Shady Grove case. As a result, Shady Grove is able to maintain a class action in federal court but would not be allowed to maintain it in New York state court. The Supreme Court remanded the case for further proceedings.
The implications of Shady Grove are potentially wide-ranging because if read expansively, the opinion could invalidate many state laws that attempt to prohibit or limit class actions. Allstate’s brief included an appendix of 59 anti-class action statutes it asserted would be invalidated, including several states’ competition and unfair business practices statutes. The Shady Grove opinion, however, signaled a few limitations on the doctrine that lower courts may adopt. The majority opinion specifically declined to rule on the effect of state laws that limit the types of damages recoverable in a class action, as opposed to laws prohibiting class actions in the first place (like in Shady Grove). Further, in what could become an important limitation to the holding in Shady Grove, Justice Stevens, in his concurring opinion, wrote that not every federal procedural rule will displace state law. The majority’s limitation and Steven’s concurrence signal that lower courts applying Shady Grove will need to engage in a detailed analysis of each statute that is potentially invalidated by Rule 23.
2 Shady Grove Orthopedic Associates, P.A. v. Allstate Insurance Co., No. 08-1008, 559 U.S. (March 31, 2010)
On April 23, the Senate Permanent Subcommittee on Investigations held a third hearing on Wall Street’s role in the financial crisis entitled The Role of Credit Rating Agencies. During the hearing, the Subcommittee admonished the major credit rating agencies for allegedly caving to market pressure in assigning top grades on subprime mortgage-backed securities, saying that the agencies consistently ignored red flags in order to please their investment bank clients and increase their market share. The hearing focused on Moody's Investors Service and Standard & Poor's Financial Services LLC, a subsidiary of McGraw-Hill Co. Inc., using them as case studies to demonstrate how the credit rating agencies' actions helped inflate, then burst, the housing bubble.
Wall Street has historically employed rating agencies to analyze risk and assign debt a "grade" that reflects the borrower's ability to pay the underlying loans. The safest debt, i.e. debt with the lowest risk of default, is assigned an AAA rating. The Senate investigation, however, has uncovered a host of problems at the rating agencies, including outdated models and inadequate data, resource shortages and, most troubling, pressure to assign top grades to investment bankers in exchange for continued rating engagements. Because investment banks hire credit rating agencies to assess the risk of their portfolios, the agencies had an incentive to give the banks the ratings they wanted, or else risk losing business to competitors — creating an inherent conflict of interest. The ultimate result: AAA-ratings were issued far too often.
In his testimony before the Subcommittee, Richard Michalek, a former vice president at Moody's, admitted that he felt constant pressure to accept risky engagements. "The independence of the group changed dramatically during my tenure," said Michalek. "The unwillingness to say 'no' grew."
E-mails made public by the Permanent Subcommittee further illustrate this problem. In an e-mail the Subcommittee obtained from April 2006, a Moody's employee complained of feeling pressure from Goldman Sachs, which was eager to start selling a high-rated product. "I am getting serious pushback from Goldman on a deal that they want to go to market with today…Goldman needs more of an explanation (I do not know how to get around this without telling them we were wrong in the past)." In another: "Let's hope we are all wealthy and retired by the time this house of cards falters. :o)," wrote an employee from Standard & Poor's Rating Agency in an internal email in December of 2006.
Indeed, in July 2007, the largest credit rating agencies announced mass downgrades of subprime mortgage backed securities within days of each other, shocking financial markets and precipitating the market's collapse. Ninety-one percent of AAA rated mortgage securities were downgraded to junk, meaning they were now the riskiest kind of security.“Investors trusted credit rating agencies to issue accurate and impartial credit ratings, but that trust was broken in the recent financial crisis,” stated Senator Carl Levin, chairman of the Permanent Subcommittee on Investigations. “By first instilling unwarranted confidence in high-risk securities and then failing to downgrade them in a responsible manner, the credit rating agencies share blame for the massive economic damage that followed.”
"Looking back, if any single event can be identified as the immediate trigger of the 2007 financial crisis, it would be the mass downgrades," said Levin. "Those downgrades hit the market like a hammer, making it clear that [they] had been a colossal mistake."
The Role of Credit Rating Agencies was the third in a series of hearings that the Permanent Subcommittee on Investigations is holding to examine the causes and consequences of the financial crisis. More information on the hearing, as well as others in the series, can be found at http://levin.senate.gov/senate/investigations/index.html.
+ May 2- 6, 2010
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MAPERS – Spring Conference
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Government Finance Officers Association Conferences
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