Sedgwick LLP Publications


Credit Crunch Digest

October 2011
By: Jennifer Quinn Broda, Matthew Ferguson, Thomas Orofino, Eric Scheiner

The subprime lending crisis and ensuing credit crunch have resulted in significant losses and numerous lawsuits involving parties to the mortgage lending and securitization process.  This digest collects and summarizes recent media reports regarding potential liability, government initiatives, litigation and regulatory actions arising from the subprime mortgage crisis and credit crunch, as well as the increasing number of reported cases of financial fraud. 


This issue focuses on recent significant developments in the multistate settlement efforts against major banks allegedly involved in the Credit Crisis; the Washington Mutual securities settlement; a potential action by the SEC against Standard and Poor’s; certain Madoff recovery efforts; a criminal sentencing in a California Ponzi scheme; a ruling in the Wilpon and Katz lawsuit potentially limiting Irving Piccard’s recovery; and the status of financial regulatory reform implementation in response to the subprime crisis and credit crunch.

Litigation and Regulatory Investigations

Fraud and Ponzi Schemes

Government and Regulatory Intervention


Litigation and Regulatory Investigations


Massachusetts Attorney General Criticizes Multistate Settlement Efforts Over Banks’ Foreclosure Practices

Dissatisfied with the ongoing multistate and federal efforts to reach a settlement agreement with major U.S. Banks over unlawful foreclosure practices, Massachusetts Attorney General Martha Coakley indicated that her office was independently preparing to file several lawsuits. A number of U.S. States, along with the U.S. Department of Justice, have accused the five largest mortgage servicers, Bank of America Corp., Citigroup Inc., JPMorgan Chase & Co., Ally Financial and Wells Fargo & Co., of failing to follow proper foreclosure procedures. Coakley stated that she has lost confidence that the banks will agree to a resolution that holds them accountable for the wrongful foreclosures at issue.


The Massachusetts Attorney General’s actions follow a September 30, 2011 announcement by the California Attorney General that her office was pulling out of the multistate negotiations and that it would commence its own investigation. During August 2011, the New York Attorney General was removed from the committee investigating foreclosure practices by the other states’ attorney generals on the basis that he was working to undermine collective settlement efforts. The New York Attorney General has objected to the settlement proposed to date on the grounds that it provides lenders with too broad of a release from future claims.  (“Mass. AG Blasts Foreclosure Talks, Preps Bank Suits,”, October 5, 2011)


Major Ratings Agency Under Scrutiny as SEC Considers Charges


In what could be the first regulatory action against one of the major credit agencies in connection with the 2008 subprime mortgage crisis, the U.S. Securities and Exchange Commission (SEC) has disclosed that it may take action against Standard & Poor’s (S&P) for securities law violations following its positive ratings for a 2007 offering of repackaged mortgage bonds that soon thereafter defaulted. S&P’s parent company, McGraw-Hill Cos Inc., (McGraw-Hill) announced that it received a Wells notice from the SEC on September 22, 2011 in connection with this offering.


McGraw-Hill stated that the Wells notice from the SEC focuses on S&P’s ratings of an August 2007 collateralized debt obligation known as “Delphinus CDO 2007-1.”  S&P’s “AAA” rating on the offering covered $947 million in liabilities and was underwritten by Mizuho International, a Japanese Bank. By December 2007, S&P began to downgrade top-bonds from the offering and by January 4, 2008 the deal was in technical default. At the end of 2008, the ratings on the offering were at “junk” status.


S&P announced that if the SEC pressed charges, it would likely attempt to settle.  Additionally, it noted that it may also have to alter its ratings practices going forward to pay civil penalties. A spokesman for ratings agencies Moody’s Investor Service and Fitch Ratings, which also rated Delphinus CDO 2007-1, stated that their respective companies did not receive Wells notices in this matter. (“SEC mulls charges against S&P in CDO case,”, September 26, 2011).


Washington Mutual Executives Agree to Settle Securities Suit


In a securities suit against former Washington Mutual (WaMu) directors and officers alleging misstatements surrounding the company’s problems in its mortgage lending business, plaintiffs have asked a U.S. District Court in Seattle to approve a $41.5 million settlement.  Investors initially commenced the lawsuit in 2004 alleging that WaMu and its officers repeatedly and improperly assured the market that WaMu had sufficient hedging practices to allow it to avoid market downturns. Following the acquisition of several other businesses and the improper integration of those companies’ information systems, plaintiffs alleged that WaMu failed to disclose that that it was unable to address fluctuating interest rates that disrupted the market.


WaMu filed for Chapter 11 bankruptcy protection 2008 and that case is ongoing. WaMu is named as a defendant in the securities lawsuit, but those claims have been stayed pending the bankruptcy action.  A fairness hearing on the proposed settlement is scheduled for May 2012.  (“Former WaMu Execs Agree To $41.5M Securities Suit Deal,”, October 6, 2011).


Fraud and Ponzi Schemes


Picard Appeals Judge Rakoff’s Ruling that Potentially Limits Madoff Recovery


On October 7, 2011, Irving Picard, the court appointed trustee for victims of Bernard Madoff’s Ponzi Scheme, filed an interlocutory appeal of Judge Jed Rakoff’s September 27, 2011 order in Picard v. Katz, et al., pending in the U.S. District Court for the Southern District of New York.  The Judge’s order characterized Madoff as a stockbroker and his clients’ withdrawals as settlement payments. Judge Rakoff also ruled in part that because Madoff was a stockbroker, his payments to former investors triggered a “safe harbor” provision of the federal bankruptcy code that protects various securities transactions from being undone.  The Judge’s order has the potential to reduce Picard’s recovery by billions of dollars.  Although Judge Rakoff’s ruling applies only to the case against the owners of the New York Mets, it could be extended to include other lawsuits Picard has brought in an effort to recoup funds issued through Madoff.  Through counsel David Sheehan, Picard has filed a motion seeking Judge Rakoff’s approval to appeal his ruling to the U.S. Second Circuit Court of Appeals.  (“Madoff Trustee Slams Judge’s Ruling, Seeks Appeal,” The Wall Street Journal, October 10, 2011).



Judge Dismisses Madoff Lawsuit Brought by Former Investors


On September 23, 2011, U.S. District Judge Deborah Batts dismissed the lawsuit styled In re: J. Ezra Merkin and BDO Seidman Securities Litigation, in the United States District Court for the Southern District of New York.  The lawsuit was filed in 2008 against Ezra Merkin (Merkin), former non-executive chairman of GMAC LLC, by former Madoff investors including New York Law School and a pension fund that had invested a total of $18 million with Merkin.  Merkin ran a so-called feeder fund that raised money to invest exclusively in Bernard L. Madoff Investment & Securities LLC.  In dismissing the lawsuit, Judge Batts held that Madoff leveraged his reputation to perpetrate his fraud for many years while some of the most sophisticated entities in the financial world (e.g., the SEC and Wall Street banks) failed to detect it.  She also found that Merkin did not deceive any of the investors who invested with Merkin, and ultimately Madoff.  The Judge also noted her decision was in line with what other courts addressing these claims had done.  (“Merkin funds win dismissal of Madoff lawsuits,” Reuters, September 26, 2011). 


“Beverly Hills Madoff” Sentenced to 7 Years in Federal Prison


Ezri Namvar and Hamid Tabatabai, owners of California based investment company Namco Capital Group (“Namco”), received a guilty verdict on four counts of wire fraud in the theft of $21 million.  Defendants were accused of creating a Ponzi scheme that lost roughly $500 million.  Although various civil lawsuits filed against Namvar and Tabatabai involve roughly 300 to 400 investors alleging fraud, the criminal case involved five victims that invested approximately $25 million with Namvar’s company, Namco Financial Exchange Corp. (“NFE”).  Namvar and Tabatabai used the victims’ money for unauthorized and undisclosed purposes, including paying off investors and creditors of Namco, rather than holding the money as promised.  Namvar was sentenced to 7 years in federal prison for wire fraud.  (“Ezri Namvar (aka Madoff of Beverly Hills) Sentenced To Prison”), Forbes, October 12, 2011).


Government and Regulatory Intervention


Nonbank Financial Companies Potentially Subject to Greater Federal Oversight


The Financial Stability Oversight Council (“FSOC”) recently voted unanimously to seek public comment on a proposed rule that provides specific standards that could potentially subject insurance companies and other nonbanks to greater federal regulation.  The FSOC was created under the Dodd-Frank financial reform legislation in order to expand existing regulatory oversight into large companies that may pose a systemic threat to the overall financial system.  Various companies and trade groups have lobbied for months against being subject to greater scrutiny by the FSOC.  According to the proposed rule, financial companies (including insurers) would be subject to greater regulatory oversight if they are holding at least $50 billion in assets and meet one of several other characteristics, including having: (i) $20 billion in debt; (ii) $3.5 billion in derivative liabilities; (iii) a 15-1 leverage ratio of total assets to total equity; (iv) short-term debt measuring 10 percent of total assets; or (v) credit-default swaps written against the company with at least $30 billion in notional value.


According to Treasury secretary and chairman of the FSO Timothy Geithner, the additional oversight of nonbank entities is “one of the most important things that the Dodd-Frank Act did.”  However, some insurance trade groups have lobbied against potentially stricter regulation:  “Property casualty insurers are not highly leveraged or interconnected and have a fundamentally different business model than banks, a fact that warrants different regulatory treatment,” said Ben McKay, a lobbyist for the Property Casualty Insurers Association. 


According to the proposed rules, the FSOC would make decisions on a case-by-case basis as to whether a company would fall under the outlined categories for further oversight.  (“Fed Oversight of Nonbank Financial Companies is Weighed,” The New York Times, October 13, 2011).


Draft Volcker Rule Gets FDIC Approval


On October 11, 2011, the Federal Deposit Insurance Corporation (“FDIC”) approved a proposed version of the so-called “Volcker Rule,” a regulation that is part of the Dodd-Frank Act reforms.  Named after former Federal Reserve chief Paul Volcker, the proposed rule seeks to limit how banks may use their own accounts for “proprietary” trading, that is, trading for their own profit.  According to the proposed version of the rule, banks would still be allowed to own a 3% stake in hedge funds, make markets, and make risky bets for their clients.  However, the Volcker rule is certain to see many changes in the coming months, as the draft rule includes more than 100 questions for public comment.  The comment period is scheduled to end on January 12, 2012.  Thereafter, regulators will analyze the comments and draft a final rule, which could take months.


The current proposed rule was drafted after input by the FDIC, the Securities and Exchange Commission, the Office of the Comptroller of the Currency and the Federal Reserve Board of Governors.  (“Volcker Rule Gets FDIC Approval,” CNNMoney, October 11, 2011.)    

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