Credit Crunch Digest
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 lawsuits Goldman Sachs is facing relating to its issuance of mortgage-backed securities; the Securities & Exchange Commission’s (SEC) division of the $285 million Citigroup settlement; a Senate investigation into the role of MF Global’s primary regulator with respect to its bankruptcy; the dismissal of Irving Picard’s suit against JPMorgan Chase & Co. and the resulting investor class action lawsuit filed; the procedural status of Picard’s “clawback” lawsuits; SEC disciplinary determinations with respect to the Madoff investigation; and implementation of Dodd-Frank initiatives.
Litigation and Regulatory Investigations
Fraud and Ponzi Schemes
Government and Regulatory Intervention
Litigation and Regulatory Investigations
Goldman Sachs Faces up to $16 Billion in MBS Lawsuits
In a November 9, 2011 regulatory filing with the SEC, Goldman Sachs acknowledged that it is facing several lawsuits seeking more than $15.8 billion in damages in connection with now soured mortgage-backed securities (MBS) that Goldman bought, sold or underwrote. This figure reportedly represents a substantial increase from its prior recognition of $485 million in similar claims in an SEC filing from only three months earlier. Goldman disclosed that a significant amount of the increase in potential liability is the result of a September lawsuit filed by the Federal Housing Finance Agency (FHFA), the agency that oversees Fannie Mae and Freddie Mac. Goldman also disclosed potential liability in lawsuits filed by European banks, HSH Nordbank, Norges Bank Investment Management and IKB Deutsche Industriebank, as well as a $275 million lawsuit by CIFG Assurance North America Inc.
Goldman and other banks have recently been under additional scrutiny by federal regulators and shareholders to more accurately disclose their exposure to potential legal liability. Other major banks, including Bank of America Corp. (BoA) and JPMorgan Chase & Co. have also recently revealed significant MBS-related legal exposure in their respective SEC filings. JPMorgan stated that it is a defendant in more than 10,000 suits as of the end of September 2011, which it believes could result in exposure of up to $5 billion. BoA disclosed that it is facing up to $3.6 billion in exposure as a result of 11 MBS-related suits. BoA also faces $58 billion in exposure from the suit by the FHFA for its MBS-related activities as a result of its acquisitions of Merrill Lynch and Countrywide Financial. (“MBS Claims Against Goldman Sachs Up 30-Fold To $16B,” Law360.com, November 9, 2011).
Judge Grills SEC Enforcement Division Over $285 Million Citigroup Mortgage Settlement
During a November 9, 2011 hearing, Federal District Court Judge Jed Rakoff voiced significant concerns with regard to the $285 million settlement agreed to by Citigroup and the SEC over the bank’s sale of mortgage-related securities. In particular, Judge Rakoff expressed serious doubts regarding whether the SEC’s enforcement action was sufficient in light of the alleged fraud on Citigroup’s customers. Judge Rakoff raised issue with the SEC’s practice of not forcing a defendant to admit any wrongdoing when settling a case and asked the SEC whether it had any interest in what the truth is. Judge Rakoff also questioned whether the SEC was serious about seeking an injunction against chronic offenders. The hearing was in response to Judge Rakoff’s series of pointed questions to the settling parties in order to consider the proposed settlement.
In light of the magnitude of the issues raised, senior SEC staff attended the hearing, including Robert S. Khuzami, the SEC’s director of enforcement, and George S. Canellos, head of its New York office. The SEC responded to the judge’s questions by stating that it has filed more than 700 enforcement actions in 2011, the most ever in a single year. It also defended its settlement practice, which is designed to avoid costly litigation and the uncertainty over a trial. The SEC also felt that there were more effective means of dealing with repeat offenders despite the judge’s repeated inquiries as to why the SEC had not brought any contempt charges in the past 10 years.
It is unclear whether Judge Rakoff will ultimately approve the settlement as currently constituted and he indicated that he would issue an opinion at a later date. Notably, Judge Rakoff previously rejected a $33 million settlement between the SEC and Bank of America over its acquisition of Merrill Lynch calling it a “sweetheart deal” done at the expense of both the shareholders and the truth. He later approved a $150 million settlement in that matter. (“Judge in Citigroup Mortgage Settlement Criticizes S.E.C.’s Enforcement,” New York Times Deal Book, November 9, 2011).
U.S. Senator Plans Investigation of MF Global Bankruptcy and Role of Its Primary Regulator
U.S. Sen. Chuck Grassley, R-Iowa, is leading an investigation into the bankruptcy of brokerage MF Global Holdings Ltd. and the role that its primary regulator, the Commodities Futures Trading Commission (CFTC), played leading up to its recent bankruptcy. MF Global collapsed as a result of holding more than $6 billion in European sovereign debt, which rating agencies recently downgraded to just above junk status. In addition, more than $600 million in client cash is reportedly missing from MF Global’s books. MF Global is the largest financial institution bankruptcy since Lehman Brothers in 2008.
Of apparent concern to the Senate investigation is the decision by the CFTC Chief Gary Gensler to recuse himself from the CFTC investigation as a result of his longstanding relationship with MF Global’s former CEO Jon Corzine. Gensler and Corzine were former colleagues at Goldman Sachs. The pair also collaborated in Washington during Corzine’s stint as a U.S. senator and Gensler’s role as a staffer to former Sen. Paul Sarbanes. Gensler has indicated that MF Global did not receive any special treatment from the CFTC as a result of his relationship with Corzine, and that his decision to recuse himself from the investigation was made to avoid any distractions from the CFTC’s investigation.
In addition to the Senate and CFTC investigations, MF Global faces additional scrutiny from the SEC as well as the FBI, which is investigating MF Global for commingling client and company cash. MF Global is also the current target of shareholder litigation. (“Sen. Eyes MF Global Collapse After CFTC Chief Exits Probe,” Law360.com, November 7, 2011).
Fraud and Ponzi Schemes
Picard Lawsuit Against JPMorgan Dismissed
Irving Picard’s lawsuit against JPMorgan Chase & Co. styled Picard v. JPMorgan Chase & Co., 11-cv-913, in the U.S. District Court, Southern District of New York, was dismissed on November 1, 2011. U.S. District Judge Colleen McMahon ruled that Picard, the trustee liquidating Bernard Madoff’s business, lacked standing to bring the lawsuit, which asserted $19 billion in claims. Specifically, Picard alleged that JPMorgan aided in the Madoff fraud, and as a result is liable to various Madoff investors. Notably, Judge McMahon’s ruling will also apply to the $2 billion in claims Picard similarly brought against UBS AG in the lawsuit styled Picard v. UBS AG, 11-cv-913, also filed in the U.S. District Court for the Southern District of New York. (“JPMorgan Wins Dismissal of $19 Billion in Madoff Claims,” Businessweek, November 3, 2011).
Former Investors File Class Action Complaint Against JPMorgan Seeking $19 Million
Less than a week after Judge McMahon dismissed Picard’s lawsuit against JPMorgan, former Madoff clients filed a class action lawsuit against the bank seeking to recover $19 million. The former Madoff clients allege that JPMorgan “chose to enable Madoff’s fraud . . . by helping to cover Madoff’s naked theft with the imprimatur of a globally recognized financial institution.” The former clients’ lawsuit was filed in the U.S. District Court for the District of New York the same court that dismissed Picard’s lawsuit against the bank. (“Madoff ex-clients file $19 billion suit against JPMorgan,” Reuters, November 7, 2011).
Hundreds of Former Madoff Investors Seek Dismissal of Picard’s Actions to Recoup Profits
On October 6, 2011, 313 former Madoff investors filed a motion to dismiss Irving Picard’s “clawback” action brought against them in 108 separate actions. Since being appointed trustee of the assets seized by Madoff, Picard has filed more than 1,000 lawsuits in an attempt to recoup funds from investors who, Picard contends, withdrew investment funds in excess of the amount they invested. Counsel for Picard maintains that the trustee only seeks profits from investors that he considers “net winners,” in an effort to place all investors on “equal footing.” In the motion to dismiss, Helen Chaitman, of Becker & Poliakoff, maintains that her clients, the investors, withdrew funds from their accounts with Madoff in good faith and, as such, should not be required to return the money. The original complaint is styled Picard v. Greiff, 11-cv-03775, U.S. District Court for the Southern District of New York. (“Madoff Investor Asks U.S. Judge to Dismiss Liquidator’s ‘Clawback’ Claims,” Bloomberg, November 10, 2011).
No Firings in Response to Investigations of SEC Employees’ Response to Madoff Scheme
On November 11, 2011, the SEC revealed that although it had disciplined eight employees for their handling of the Madoff Ponzi scheme, it did not fire any employees. The disciplinary actions ranged from a 30-day suspension without pay combined with a reduction in salary to “counseling memos.” The internal investigation was originally conducted in 2009 and involved 21 employees, 10 of whom left the SEC by the summer of 2011. After conducting its internal investigation, the SEC hired outside law firm Fortney & Scott to provide recommendations for disciplinary actions. Fortney & Scott determined that the SEC received six warnings about Madoff’s trading business over 16 years. However, because of inexperience and delays in examinations, Madoff was able to continue his scheme for years. (“SEC Discipline Over Madoff,” The Wall Street Journal, November 12, 2011).
Government and Regulatory Intervention
Regulator Tasked to Operate on Limited Budget
Under the Dodd-Frank financial reform law, the Commodity Futures Trading Commission (CFTC) is now tasked with overseeing the over-the-counter-derivatives market. The agency, however, will likely be trying to achieve this new oversight under a tight budget. U.S. congressional negotiators have agreed to a $205 million budget for the CFTC for the coming year. However, the Obama Administration had asked the congressional committee for a $308 million budget, in order to ensure the CFTC could take on its larger regulatory role.
According to reports, CFTC officials have stated that they are overwhelmed by their new responsibilities under Dodd-Frank. The $205 million budget, however, is a slight increase from its current budget of $202 million. While Democratic lawmakers have criticized their Republican counterparts for not agreeing to the White House’s budget proposal, many Republicans believe the CFTC should do more with less. “The commission should not miss the opportunity to utilize technology to the fullest to automate our surveillance and risk management activities,” said Scott O’Malia, one of the CFTC’s two Republican commissioners. (“Tight Budget Set for U.S. Markets Regulator,” The Financial Times, November 16, 2011; “Congress Slashes Financial Watchdog,” Politico, November 15, 2011).
Federal Authorities Aggressively Investigating Ponzi Schemes Nationwide
By September 30, 2011, the end of the CFTC’s fiscal year, the agency brought 32 enforcement cases against suspected Ponzi schemes. This is not only a 45 percent increase from 2010 but also a record high for the CFTC. In the same time period, the Federal Bureau of Investigation (FBI) opened more than 1,000 investigation inquiries, a 150 percent increase from 2008.
According to federal authorities, because of the Madoff fraud, the public is more acutely aware of potential fraudulent investment schemes and are sending in tips and other information to federal authorities much earlier than before. Madoff’s fraud went undetected for decades, causing federal regulators to step up their scrutiny of Ponzi schemes. “Ponzi schemes are one of our top priorities within financial crimes,” Timothy A. Gallagher, the FBI’s section chief for financial crimes, said. “It’s right up there with corporate fraud and insider trading.”
According to reports, almost one-third of the CFTC’s enforcement cases last year involved Ponzi schemes. These cases totaled $279 million. (“Post-Madoff, a Greater Awareness of Ponzi Schemes,” The New York Times, November 14, 2011).